An option is a financial market instrument that grants one party to the contract—the buyer, or option holder— the right to require the other party, the seller (i.e., the option writer), to buy or sell the underlying instrument during or after the expiration of a specified period at a predetermined price, known as the strike price, while the other party is obligated to sell or buy this underlying instrument. The underlying instrument of options is typically shares, equity securities, bonds, and others.
Put Options vs. Call Options, or Why “Bet” on Options?
There are two basic types of options based on the right to buy. The first type is put options, where the option holder has the right to sell the underlying asset, anticipating a sharp decline in the price of the underlying asset, while the option writer expects stability or growth. The other type of options are call options, where the option holder has the right, but not the obligation, to buy the underlying instrument, anticipating an increase in the price of the underlying instrument, while the option writer anticipates stability or a decline. An option offers the buyer a significant advantage in the ability to not exercise the option if the expected price movement of the underlying instrument does not occur, as the buyer always has the right, but not the obligation, to sell or buy the underlying instrument, and the buyer’s risk is thus limited only to the cost of acquiring the option itself.
Option Price
The option buyer is obligated to pay the seller a fee, known as the option price or option premium. The option price consists of the option’s intrinsic value and time value.
Option price = intrinsic value & time value
The intrinsic value of a put option is the positive difference between the option’s strike price and the current price of the underlying instrument (“spot price”), while the intrinsic value of a call option is the positive difference between the current price of the underlying instrument and the option’s strike price. The intrinsic value of an option cannot be less than zero.
intrinsic value = option strike price – current price of the underlying instrument
The time value of an option refers to the option price after subtracting the intrinsic value of the option. During the life of the option, the time value of the option gradually decreases until it equals zero at the moment of expiration.
time value = option price – intrinsic value of the option
American and European-style options
Depending on when the option can be exercised, we distinguish between American-style options and European-style options. The American-style option is relatively more advantageous for the option buyer, as the option can be exercised at any time during its term, which represents a significant disadvantage for the seller. Unlike the American-style option, the European-style option can only be exercised within a short time frame—on a single specific day, which is the expiration date of the option. It should be noted that these terms do not reflect current practice in American or European markets, and the distinction is purely historical; both markets utilize both types of options.
Employee Stock Option and Stock Plans
Employee stock option plans are typically designed to provide employees with the opportunity to purchase company shares at a predetermined price (the “exercise price”) within a specified time frame. The primary goal of a guaranteed employee option is to align employees’ interests with the company’s long-term success.
Employee plans can be categorized as option plans and stock plans.
Option plans involve an employee receiving a certain number of options with a predetermined exercise price; upon meeting certain conditions—such as remaining with the company—the employee gains the right to exercise the option to purchase shares at the predetermined exercise price. The employee can therefore determine for themselves whether it is advantageous to exercise the option, based on whether the market price of the stock is higher than the exercise price.
Under current legislation, an employee realizes income from such a plan when they exercise their stock options, and this income represents the difference between the market price of the shares on the date of option exercise and the exercise price of the shares, with the tax treatment of employee stock option programs governed by the Income Tax Act.
The second type of plan is a stock plan. Stock plans are similar to stock option plans primarily in that they are based on the transfer of a predetermined number of shares after the expiration of a predetermined period, subject to the fulfillment of specified conditions, just as with stock option plans. The uniqueness of stock plans lies primarily in the discount granted to the employee when purchasing shares; if the shares are transferred directly to the employee, an option contract is not required.
It is also worth mentioning the concept of phantom stock (“phantom stocks”), which represent a set of incentive compensation tools; the employee does not directly acquire shares but only certain rights typically associated with share ownership, particularly the right to receive a regularly paid bonus based on the company’s business performance.
Phantom stocks can also be not only granted directly but can take the form of specific option programs—“phantom stock options.” A phantom stock option plan is typically allocated primarily to employees and contractors (individuals) who support the company in developing its business. Phantom stock option plans can be tailored to meet the specific needs of the company and its employees. They can be designed as short-term or long-term incentive plans, with the duration and payout structure varying depending on the company’s goals and the employees’ responsibilities. In addition, these plans can be structured to include performance-based bonus calculations, such as meeting sales targets or achieving specific company financial goals, which further helps align the interests of employees and the company toward strong business results. When the time comes to pay out bonuses from a phantom stock plan, employees are typically paid a cash amount based on the value of their phantom shares, which is generally calculated as the difference between the value of the employee’s phantom shares at the beginning of the plan and their value at the end of the plan.
In conclusion, it can be stated that today neither an option plan nor a stock plan represents a potential disadvantage or a tax disadvantage for the employee. However, we will address the taxation of employee shares and options in the next article.
