WHAT IS AN OPTION?
An Option is a right but not an obligation to buy or sell an asset or carry out some activity. Here we are talking about financial options which relate to financial transactions.
SOME CONCEPTS IN OPTIONS
1. Call and Put options
A Call option gives the right but not an obligation to buy an asset.
A Put option gives the right but not an obligation to sell an asset.
2. Strike/Exercise Price
Strike price or exercise price is the price at which the asset can be bought (in case of a call option) and sold (in case of a put option).
3. Expiration Date
The expiration date is the date after which the option ceases to exist. A European option can be exercised only at the expiration date whereas an American option can be exercised any time till the expiration date.
4. In the money
An ‘in the money’ option has some value to the holder.
For a call option, the option is ‘in the money’ when the market price of the asset is higher than the strike price and immediately exercising the option gives the holder profit equal to (market price – strike price). The holder buys the asset at the lower strike price exercising the option and sells in open market at the higher market price.
For a put option, the option is ‘in the money’ when the market price of the asset is lower than the strike price and immediately exercising the option gives the holder profit equal to (strike price – market). The holder buys the asset from the open market at the lower market price and sells the asset at the higher strike price exercising the option.
5. Out of money
An ‘out of money’ option has NO value to the holder.
In case of a call option, the option is ‘out of money’ when the strike price is lower than the market price. In case of a put option, the option is ‘out of money’ when the strike price is higher than the market price.
WHAT IS AN EMPLOYEE STOCK OPTION?
An Employee Stock Option is fundamentally a call option (on own shares) issued by an employer to its employees. It is an alternative form of compensation with which companies (especially startups who want to preserve cash) use to reward employees.
An Employee Stock Option Plan (ESOP) or Employee Stock Option Scheme (ESOS) is the scheme under which the stock options are issued and granted to the employees.
HOW DOES IT WORK?
Companies can issue stock options to employees directly or through a trust as per the rules of SEBI (Share-Based Employee Benefits) regulations, 2014. The companies have the freedom to decide the strike price for the options.
The options can be exercised after a period called the ‘vesting period’. The minimum vesting period as the regulations is one year. Companies can opt for some lock-in period as well. Before the options are vested, the employees (option holders) do not have any voting rights or dividend rights associated with them.
The issuing company has the right to forfeit or return any payment by the employees in case the options are not vested.