Management Glossary

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stock options
A stock option gives the holder of the option the right to buy or sell a set number of shares of a company's stock at a particular price. Stock options given to employees as part of their compensation packages give those employees the right to buy stock at a set price, typically higher than the market price on the day the option is granted, as an incentive (so the theory goes) to work hard toward making the firm profitable and, therefore, increasing the stock price in the market. Employee stock options generally must be exercised (i.e., the shares allowed under the option must be purchased for the set price) within a set time-frame. If, during that period, the stock price on the open market never goes above the price specified in the option (referred to as the "strike price") it would be foolish for the employee to exercise the option because he or she could buy the stock for less on the open market. If, on the other hand, the stock price goes well above the strike price the employee can, potentially, make a fortune by exercising the option and immediately selling the stock. Employee stock options have fallen into some disrepute because of the incentive they create to take actions that will boost the stock price in the short-term to the long-term detriment of the company. If these incentives are too strong, less scrupulous individuals might undertake illegal activities to boost the stock price, as happened in some notorious business scandals. Stock exchanges also create options that allow the holder of the option to buy ("call options") or sell ("put options") a stock at a set price within a specified period. These options are traded on the open market and their price is determined based on which direction investors think the price of the underlying stock will go and by how much it will move during the option period. This option price also takes into account the risk of these guesses being wrong.
Contributed by: Managerwise Staff

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