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A stock option in which the exercise price is higher than the market price of the underlying stock. For example, a stock option is "underwater" if its exercise price is $10 but the stock price is $8. This makes the option worthless until the stock price rises above the exercise price. In other words, it would cost less to buy the stock on the open market than to exercise the underwater option.
For more on this topic, see this website's section Volatility.
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