A stock option, also known as a derivative, is a contractual right, but not an obligation, to purchase (call) or sell (put) shares of a company’s stock at a future date and at a predetermined, or strike, price. A stock option fulfills two purposes simultaneously: It serves as a hedging instrument designed to reduce the financial risk of an investor holding a particular financial asset, and it serves as a speculative financial instrument by requiring a second investor to assume more risk in return for a potentially higher financial reward.
Employee stock options are call options and are not publicly traded. Employee stock options must be held by the employee for a specified period of time, termed the vesting period, before the option can be exercised. Employee stock options in the United States consist of two types: incentive stock options and nonqualified stock options. The difference between the two is that the profits from incentive stock options are taxed as a capital gain while those from nonqualified stock options are taxed as ordinary income.
Stock options have long been a component of corporate executive compensation packages. They have become increasingly popular over the past few decades as U.S. companies shifted away from accounted earnings to stock price as the primary measure of corporate performance. Granting stock options to corporate executives, it is argued, helps align their interests with those of shareholders by linking executive compensation to company stock price performance. In the 1990s employee stock options became more widely used in typical employee compensation packages for two reasons. First, unlike salaries, employee stock options did not cost companies anything. Second, they were used to attract and retain motivated and entrepreneurial employees, especially in booming high-tech and cash-strapped start-up companies.
But employee stock options have been criticized for their potential to become worthless, or “underwater,” should the company stock price deteriorate. This was often the case after the dot-com crash in the late 1990s, which left many employees holding worthless stock options. Another criticism claims that the rules for reporting and accounting employee stock options are insufficient. This criticism arose after evidence surfaced that major corporations routinely backdated executive stock options in order to ensure higher financial rewards for those executives. Furthermore, there are criticisms of the Black-Scholes pricing model that is used in valuing stock options, and questions pertaining to whether employee stock options should be valued at the time they are granted or when they are exercised. These criticisms arose after the 2002 Sarbanes-Oxley Act strengthened compensation reporting and accounting measures and required companies to expense employee stock options. The act was a response to the wave of corporate scandals that surfaced in the United States between 1999 and 2001, in which corporate executives at such notable companies as Enron and WorldCom cashed in their stock options after artificially inflating their company’s stock price. Finally, employee stock options have been criticized as contributing to the increasing polarization of wealth, since the median total realized compensation (including gains from stock options) of the top Fortune 500 chief executive officers since the 1970s has nearly quadrupled while the real wages of workers has declined.
SEE ALSO Bull and Bear Markets; Equity Markets; Expectations; Financial Markets; Hedging; Risk; Stock Exchanges; Stocks; Stocks, Restricted and Unrestricted; Uncertainty
Hall, Brian J., and Kevin J. Murphy. 2003. The Trouble with Stock Options. Journal of Economic Perspectives 17 (3): 49–70.
Jayson J. Funke