How an option is issued

The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction i. An option that conveys to the owner the right to buy at a specific price is referred to as a call ; an option that conveys the right of the owner to sell at a specific price is referred to as a put. The seller may grant an option to a buyer as part of another transaction, such as a share issue or as part of an employee incentive scheme, otherwise a buyer would pay a premium to the seller for the option.

Stock options were just a footnote. Now the reverse is true.

The Pay-to-Performance Link

How an option is issued astounding speed, stock option grants have come to dominate the pay—and often the wealth—of top executives throughout the United States. Michael Eisner exercised 22 million options on Disney stock in alone, netting more than a half-billion dollars. In total, U. It would be difficult to exaggerate how much the options explosion has changed corporate America. But has the change been for the better or for the worse?

Certainly, option grants have improved the fortunes of many individual executives, entrepreneurs, software engineers, and investors.

What are Employee stock options (ESO)?

Their long-term impact on business in general remains much less clear, however. Option grants are even more controversial for many outside observers. The grants seem to shower ever greater riches on top executives, with little connection to corporate performance.

They appear to offer great upside rewards with little downside risk. And, according to some very vocal critics, they motivate corporate leaders to pursue short-term moves that provide immediate boosts to stock values rather than build companies that will thrive over the long run.

The Downside Risk

As the use of stock options has begun to expand internationally, such concerns have spread from the United States to the business centers of Europe and Asia. Options do not promote a selfish, near-term perspective on the part of businesspeople.

Quite the contrary.

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Options are the best compensation mechanism we have for getting managers to act in ways that ensure the long-term success of their companies and the well-being of their workers and stockholders.

Stock options are bafflingly complex financial instruments. As a result, companies often end up having option programs that are counterproductive.

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I have, for example, seen many Silicon Valley companies continue to use their pre-IPO programs—with unfortunate consequences—after the companies have grown and gone public. The Pay-to-Performance Link The main goal in granting stock options is, of course, to tie pay to performance—to ensure that executives profit when their companies prosper and suffer when they flounder.

Many critics claim that, in practice, option grants have not fulfilled that goal. Executives, they argue, continue to be rewarded as handsomely for failure as for success. As evidence, they either use anecdotes—examples of poorly performing companies that compensate their top managers extravagantly—or they cite studies indicating that the total pay of executives in charge of high-performing companies is not much different from the pay of those heading poor performers.

The studies are another matter.

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Virtually all of them share a fatal flaw: they measure only the compensation earned in a given year. As executives at a company receive yearly option grants, they begin to amass large amounts of stock and unexercised options.

The Options Industry Council (OIC) - What is an Option?

When the shifts in value of the overall holdings are taken into account, the link between pay and performance becomes much clearer. By increasing the number of shares executives control, option grants have dramatically strengthened the link between pay and performance.

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For both measures, the link between pay and performance has increased nearly tenfold since Tying Pay to Performance Given the complexity of options, though, it is reasonable to ask a simple question: if the Million Option Strategy is to align the incentives of owners and managers, why not just hand out shares of stock? The answer is that options provide far greater leverage. For a company with an average dividend Million Option Strategy and a stock price that exhibits average volatility, a single stock option is worth only about one-third of the value of a share.

Employee stock options March 24, AM ET An employee stock option is the right given to you by your employer to buy "exercise" a certain number of shares of company stock at a pre-set price the "grant," "strike" or "exercise" price over a certain period of time the "exercise period". Most options are granted on publicly traded stock, but it is possible for privately held companies to design similar plans using their own pricing methods. Usually the strike price is equal to the stock's market value at the time the option is granted but not always.

The company can therefore give an executive three times as many options as shares for the same cost. In addition to providing leverage, options offer accounting advantages. The accounting treatment of options has generated enormous controversy.

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On the other side are many executives, especially those in small companies, who counter that options are difficult to value properly and that expensing them would discourage their use. The response of institutional investors to the special treatment of options has been relatively muted.

Understanding Your Employee Stock Options

They have not been as critical as one might expect. There are two reasons for this. First, companies are required to list their option expenses in a footnote to the balance sheet, so savvy investors can easily figure option costs into expenses. Even more important, activist shareholders have been among the most vocal in pushing companies to replace cash pay with options.

In my view, the worst thing about the current accounting rules is how an option is issued that they allow companies to avoid listing options as an expense. That discourages companies from experimenting with new kinds of plans.

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As just one example, the accounting rules penalize discounted, indexed options—options with an exercise price that is initially set beneath the current stock price and that varies according to a general or industry-specific stock-market index.

Although indexed options are attractive because they isolate company performance from broad stock-market trends, they are almost nonexistent, in large part because the accounting rules dissuade companies from even considering them. The idea of using leveraged incentives is not new.