Definition: A stock option is the right to purchase a specific number of common shares at a fixed price over a set period of time at a future date. In other words, it gives the owner of the option the ability to purchase shares at a future date for a specific price regardless of what the market price is.
Let’s take a look at an example.
Tile Co. offers its top management options to purchase 100 shares of $5 par value stockfor $75 per share. These offers must be expires in 12 months. The current market value of Tile Co. stock is $70. Obviously, the management would not want to exercise these options today since the fair market value is less than the exercise price. Instead, they will wait and hope that the value of the company will increase over the next 12 months.
Let’s assume that 9 months later, Tile Co. is trading for $90 per share. The management can exercise their options to purchase shares for $75 per share even though the market value is $90.
What Does Stock Option Mean?
Stock options can be purchased on the open market, but they are more commonly distributed by the corporation to its employees. Options are typically given to employees and managers as part of their compensation packages or bonus arrangements. Both the company and the employee typically benefits from this arrangement.
By giving managers a stake in the company (or the potential to purchase a shares in the company), the employees are more likely to stay with the company, focus on improving performance, and accomplish long-term goals. In a sense, options help motivate employees to benefit the company more than standard compensation.
The employee benefits from this arrangement too. Since options are a speculative investment, the employees could make far more on their options than their wages if the company does well. Also, the tax code allows employees to defer the taxes on this form of compensation, so they don’t have to pay income taxes on the options before they are exercised.