Legal Definitions - stock option

A stock option is a contractual agreement that grants an individual the right, but not the obligation, to purchase a specific number of shares of a company's stock at a predetermined price (known as the "strike price" or "exercise price") within a specified period.

This right is often used as a form of employee compensation, allowing individuals to benefit if the company's stock value increases. It can also be traded by investors who anticipate future price movements. If the market price of the stock rises above the strike price, the option holder can "exercise" the option, buy the shares at the lower strike price, and potentially sell them for a profit. If the market price falls below the strike price, the holder can simply choose not to exercise the option, letting it expire without obligation.

• Example 1: Employee Compensation in a Startup

  Imagine Sarah, a software engineer, joins a promising tech startup. As part of her employment package, she is granted stock options to purchase 5,000 shares of the company's stock at a strike price of $5 per share. These options vest over four years, meaning she gradually earns the right to exercise them, and they expire in ten years.

  How this illustrates the term: Sarah has the right, but not the obligation, to buy 5,000 shares at a fixed price ($5) for a defined period. If the startup becomes highly successful and its stock price climbs to $50 per share, Sarah can exercise her options, buy the shares for $5 each, and immediately sell them on the open market for $50 each, realizing a significant profit. If the company struggles and the stock price never exceeds $5, she simply lets the options expire, losing nothing beyond the potential opportunity.

• Example 2: Investor Speculation on a New Product

  An investor, David, believes that a major electronics company is about to release a revolutionary new gadget that will significantly boost its stock price. The company's stock is currently trading at $100 per share. Instead of buying 100 shares for $10,000, David buys a call option contract that gives him the right to purchase 100 shares at a strike price of $110 per share, expiring in three months. He pays a small premium for this option.

  How this illustrates the term: David has purchased the right to buy shares at a set price ($110) within a specific timeframe (three months). If the new gadget is a huge success and the stock price jumps to $150, David can exercise his option, buy 100 shares for $110 each, and then sell them for $150 each, making a substantial profit. If the gadget flops and the stock price drops below $110, David can choose not to exercise the option, and his only loss is the premium he paid for the option, not the full value of 100 shares.

• Example 3: Executive Performance Incentive

  The board of directors of a large manufacturing corporation grants its CEO a substantial number of stock options, allowing her to purchase 100,000 shares at the current market price of $60 per share. These options are structured to vest only if the company achieves specific growth targets and its stock price increases by at least 25% over the next three years.

  How this illustrates the term: This scenario demonstrates stock options as a performance incentive. The CEO has the right to buy shares at a fixed price ($60), but this right is conditional upon meeting certain company performance metrics and is valid for a defined period. This motivates the CEO to drive the company's success, as the options become valuable and profitable only if the stock price rises significantly above the $60 strike price, directly benefiting from the company's improved performance.