Stock Options Explained

Let us get down to the basics of modern finance. Joint stock companies aka: incorporated companies, have a unique way of raising capital. These companies invite capital from the public, who invest small quantities of finances, in the companies. Millions of such share holders (who are also known as investors), make up a mammoth share capital. These investments are known as 'shares', which are tradeable assets through stock exchanges. Thus, these share holders who have invested in the companies, can benefit from two things, namely, a dividend that is paid by the company at the end of a fiscal year, or the shareholder can simply sell off the share for a profit with the help of a stock exchange.

A stock option is a concept that is closely associated with shares. In most countries, such as the United States of America, this option is simply referred to as a stock option, but in many commonwealth countries, such as the United Kingdom, it is known as a share option. Let us get to know more about this financial instrument.

Meaning and Definition

The concept of stock options is a complicated one, but here's a simplified version of the definition.

In the usage of stock options, a privilege or rather a right is given by a company or a party to another party where a buyer of stock (or shares), is empowered to buy or sell a stock (share or shares), at an agreed price within an agreed period of time or on a specified date. It must be noted that stock option is a right and not an obligation.

Hence, basically stock options work in a mechanism that is given as follows.

1. Party A is in possession of a certain amount of shares of 'X' company. Party A sells the stock option to party B for a small sum of money.
2. At the designated date, party B has two options in front of it. The first option is - Party B can purchase the designated number of shares from Party A. Or, party B can go with the second option of not purchasing stock options. In such a situation the money that has been paid to purchase stock option rights, is not refunded by the party A.

In short, a sale or purchase of stock options is basically a sale of rights and not the actual sale or purchase of shares.

Legal Terminologies Involved
Theoretically speaking, a stock option transaction is a legally enforceable agreement, where the buyer purchases rights from the seller for a small price. In the agreement, the stock or shares are purchased by the buyer (if he chooses to do so), at a fixed price that is set during the creation of a stock options agreement, within a predetermined and specified time period. The specified amount of sale is known as the grant or strike price (market price of the shares do not come into the picture at all in such a case), and the time period is known as vesting period.

Usage, Call and Put

In the recent past, with the widespread evolution of joint stock companies and usage of shares and stock exchanges, people have started commonly using the stock options. Stock options are often used by investors, financial institutes, insurance companies, mutual fund managers, etc. In addition to that, company takeovers, mergers, acquisitions, amalgamation, etc, are also achieved with the help of stock options. Financial speculators often resort to this concept to purchase assets that have a rising market projection. One must note that options are not restricted to share stock but are also applicable for normal conventional fixed assets, such as real estate.

People commonly resort to two types of stock options, namely call and put. A call stock option gives the owner of the option, a right (but not obligation) to buy the stock. A put stock option on the other hand gives the owner rights (but not obligation) to sell the stock.

Employee Stock Options
Of late many companies have resorted to this concept of rewarding their employees. Right from the top management to the workers, all employees are given a stock option of their company's shares. This provision has phenomenally affected the human resource management as well as financial management, as employees tend to be psychologically integrated into the company and an overwhelming feeling of integrity is experienced. On the whole, employees are made happy as they can easily own a genuine amount of share of their company irrespective of their market price or availability.

It can be safely concluded that stock options is an excellent tool for purchase and sale of stocks and shares. Though the legal provisions and compliance of this tool differ from country to country as a result of the legal systems, but the basic working is almost the same. A stock option is a great current asset on the balance sheet and must be used to the best possible extent so that sufficient liquid finances are available.