Stock Options

In Depth

Stock options give executives the right — but not the obligation — to buy company stock at a predetermined price (the exercise or strike price) at some point in the future. If the stock price rises above the strike price, the option becomes "in the money" and the executive can exercise it to capture the difference as profit. If the stock price falls below the strike price, the options are "underwater" and worthless. Options typically vest over a three-to-four-year period and have a ten-year expiration. During the 1990s and early 2000s, stock options were the dominant form of executive equity compensation, fueled by favorable accounting treatment that allowed companies to grant options without recording an expense. The passage of FAS 123R in 2005, which required companies to expense options at fair value, contributed to a shift toward restricted stock units (RSUs) and performance share units (PSUs) as the preferred equity vehicles. Nevertheless, some companies — particularly in the technology sector — continue to grant options because they provide zero value if the stock price does not increase, creating a strong alignment between executive incentives and share price appreciation. The Black-Scholes model or a binomial lattice model is typically used to value options for the Summary Compensation Table in SEC filings.