An option is a financial market instrument whereby one party to the contract, the buyer, i.e. the option holder, has the right to require the other party, the seller, i.e. the option writer, to buy or sell the underlying instrument during or after a specified period at a predetermined price, the so-called strike price, whereby the other party is obliged to sell or buy this underlying instrument. The underlying instrument of options is usually 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 instrument, assuming a sharp decline in its price, while the option writer expects stability or growth. The other type of option is a call option, where the option holder has the right, but not the obligation, to buy the underlying instrument, assuming that the price of the underlying instrument will rise, while the option writer expects stability or a decline. An option represents a huge advantage for the buyer in that they can choose not to exercise the option if the price of the underlying instrument does not develop as expected, 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 to the cost of purchasing the option itself.
Option price
The buyer of the option is obliged to pay the seller a fee, known as the option price or option premium. The option price consists of the intrinsic value of the option and the time value of the option.
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 = strike price of the option – current price of the underlying instrument
The time value of an option is the option price after deducting the intrinsic value of the option. During the life of the option, the time value of the option gradually decreases until it is zero at the time the option expires.
time value = option price – intrinsic value of the option
American and European options
Depending on when the option can be exercised, we distinguish between American-style options and European-style options. American-style options are relatively more advantageous for the option buyer, as the option can be exercised at any time during its term, which is a significant disadvantage for the seller. Unlike American options, European options can only be exercised within a short period of time – on a specific day, which is the expiry date of the option. It should be noted that these terms do not represent actual practice on the American or European markets at present and the designation is only for historical reasons; both markets use both types of options.
Employee stock option and share plans
Employee stock option plans are designed to give employees the opportunity to purchase company shares at a predetermined price (the exercise price) within a specified time frame. The primary objective of a guaranteed employee option is to align the interests of employees with the long-term success of the company.
Employee plans can be divided into option plans and stock plans.
An option plan is when an employee receives a certain number of options with a predetermined exercise price and, upon fulfilling certain conditions, such as remaining with the company, has the option to purchase shares at the predetermined exercise price. The employee can therefore decide for themselves whether it is advantageous to exercise the option, based on whether the market price of the share is higher than the exercise price.
Under current legislation, the employee receives income from such a plan when they exercise their employee options, and this income represents the difference between the market price of the shares on the date of exercise of the option and the exercise price of the shares, with the tax regime for employee option plans being governed by the Income Tax Act.
The second type of plan is a share plan. Share plans are similar to option plans in that they are based on the transfer of a pre-agreed number of shares after a pre-agreed period, subject to certain conditions being met, as in the case of option plans. The uniqueness of share plans lies mainly in the discount granted to the employee when purchasing shares, as the shares are transferred directly to the employee, so no option contract is required.
It is also worth mentioning the concept of phantom stocks, which are a set of incentive remuneration instruments whereby the employee does not directly acquire shares, but only certain rights normally associated with share ownership, in particular a bonus paid regularly depending on the performance of the company.
Phantom shares may also be provided not only directly, but may also represent specific option programs - "phantom stock options". A phantom option plan is usually allocated primarily to employees and suppliers (natural persons) who support the company in the development of its business. Phantom 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 objectives and the employees' roles. In addition, these plans can be structured to include performance-based bonus calculations, such as meeting sales targets or achieving specific financial goals of the company, which further helps align the interests of employees and the company on good business results. When the time comes to pay bonuses from a phantom stock option plan, employees are usually paid a cash amount based on the value of their shadow shares, which is generally calculated as the difference between the value of the employee's shadow shares at the beginning of the option plan and their value at the end of the option plan.
In conclusion, it can be said that today, neither stock option plans nor stock plans represent a potential disadvantage or tax disadvantage for employees. However, we will discuss the taxation of employee shares and options in our next article.
