Stock Options

Definition

Stock options are financial instruments that give the holder the right, but not the obligation, to buy or sell a company's stock at a predetermined price within a specific time period. They are an important tool in the relationship between shareholders and company management, as they can be used to align the interests of executives with those of the shareholders.

5 Must Know Facts For Your Next Test

1. Stock options are often used as a form of executive compensation, aligning the interests of management with those of shareholders.
2. The predetermined price at which the stock can be bought or sold is known as the strike price or exercise price.
3. Stock options can have a vesting period, which means the employee must wait a certain amount of time before they can exercise the options.
4. Exercising a call option allows the holder to buy the stock at the strike price, while exercising a put option allows the holder to sell the stock at the strike price.
5. The value of a stock option is derived from the underlying stock price, the strike price, the time to expiration, and volatility of the stock.

Review Questions

• Explain how stock options can be used to align the interests of company management and shareholders.
  • Stock options can be used as a form of executive compensation, where managers are granted the right to buy company stock at a predetermined price. This aligns the interests of management with those of shareholders because if the stock price rises, the executives can exercise their options and profit, which incentivizes them to make decisions that will increase the company's stock price and benefit shareholders. Additionally, stock options often have a vesting period, which encourages executives to remain with the company long-term and make decisions that will drive sustained growth and shareholder value.
• Describe the difference between call options and put options and how they are used in the context of stock options.
  • Call options give the holder the right to buy the underlying stock at a specified price, while put options give the holder the right to sell the underlying stock at a specified price. In the context of stock options, call options are more commonly used as a form of executive compensation. When executives are granted call options, they have the right to buy the company's stock at the strike price, which incentivizes them to increase the stock price so they can exercise the options and profit. Put options are less commonly used in executive compensation, but they could be used to protect against downside risk if the stock price falls.
• Analyze how the vesting period of stock options can impact the relationship between shareholders and company management.
  • The vesting period of stock options, which is the time an employee must wait before they can exercise their options, can have a significant impact on the relationship between shareholders and company management. A longer vesting period encourages executives to make decisions that will drive long-term growth and shareholder value, as they will only be able to profit from their options if they remain with the company for the duration of the vesting period. This helps to align the interests of management with those of shareholders, as executives are incentivized to make decisions that will benefit the company and its shareholders over the long-term, rather than focusing on short-term gains. Conversely, a shorter vesting period may incentivize executives to make decisions that boost the stock price in the short-term, even if those decisions are not in the best interests of the company and its shareholders in the long-run.

Related terms

Call Option: A call option gives the holder the right to buy the underlying stock at a specified price within a certain time period.

Put Option: A put option gives the holder the right to sell the underlying stock at a specified price within a certain time period.

Vesting: The process by which an employee's right to a company's stock options or restricted stock becomes unconditional.