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What is a 'Stock Option'

A stock option is a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period of time. American options, which make up most of the public exchange-traded stock options, can be exercised any time between the date of purchase and the expiration date of the option. On the other hand, European options, also known as "share options" in the United Kingdom, are slightly less common and can only be redeemed at the expiration date.

BREAKING DOWN 'Stock Option'

The stock option contract is between two consenting parties, and the options normally represent 100 shares of an underlying stock.

Put and Call Options

A stock option is considered a call when a buyer enters into a contract to purchase a stock at a specific price by a specific date. An option is considered a put when the option buyer takes out a contract to sell a stock at an agreed-on price on or before a specific date.

The idea is that the purchaser of a call option believes that the underlying stock will increase, while the seller of the option thinks otherwise. The option holder has the benefit of purchasing the stock at a discount from its current market value if the stock price increases prior to expiration. If, however, the purchaser believes a stock will decline in value, he enters into a put option contract that gives him the right to sell the stock at a future date. If the underlying stock loses value prior to expiration, the option holder is able to sell it for a premium from current market value.

The strike price of an option is what dictates whether or not it's valuable. The strike price is the predetermined price at which the underlying stock can be bought or sold. Call option holders profit when the strike price is lower than current market value. Put option holders profit when the strike price is higher than the current market value.

Employee Stock Options

Employee stock options are similar to call or put options, with a few key differences. Employee stock options normally vest rather than having a specified time to maturity. This means that an employee must remain employed for a defined period of time before he earns the right to purchase his options. There is also a grant price that takes the place of a strike price, which represents the current market value at the time the employee receives the options.

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