A stock option is a contractual agreement that allows the holder, typically an employee or an investor, to buy or sell a specified number of shares of a company's stock at a predetermined price, known as the exercise or strike price, within a set time period. Stock options are often used as a part of employee compensation packages, incentivizing employees by aligning their interests with those of the company shareholders. For instance, if an employee has stock options priced at $50 per share and the market price of the stock rises to $70, the employee can exercise the option to buy the stock at the lower price, thus gaining a benefit. Stock options may include terms and conditions, such as vesting periods during which the employee must remain with the company before the option can be exercised.
In finance, stock options are also traded as derivative instruments in the open market, used by investors to speculate or hedge against stock price movements. For example, an investor believing a stock's price will rise might purchase a call option, allowing them to buy the stock at a fixed price. Conversely, a put option would enable them to sell stock at a fixed price, providing a hedge against declining prices.
Some common forms of employee stock options are Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs), each having specific tax implications.