Option

What it means

An option is a contract that gives its holder the right, but not the obligation, to buy or sell a given asset at a pre-agreed price, the strike price, on a set date or during a set period. The other party, the option writer, must complete the trade if the holder decides to exercise. In return for this asymmetric position the writer receives a premium.

There are two basic types. A call option gives the right to buy and pays off when the market price rises above the strike. A put option gives the right to sell and protects against a fall in price. By exercise timing, a European option can be exercised only on the expiry date, while an American option can be exercised at any time until expiry.

An option is a derivative; its value depends on an underlying asset such as a share, currency, interest rate or commodity. Its main advantage is that the buyer's maximum loss is limited to the premium paid, while the potential gain can be much higher.

How it works in practice

Companies use options mainly for hedging. An exporter expecting a dollar payment in three months can buy a currency option that guarantees a minimum rate while keeping the upside if the rate moves favourably. Unlike a forward, it does not give up a possible gain, but it pays the premium up front.

The second area is employee plans. Under an ESOP, key people receive options over a stake in the company that they can exercise only after vesting conditions are met, for example after working a certain number of years. In a Slovak s. r. o., agreements on a future transfer of an ownership interest or phantom shares are often used instead of classic options.

The third area is shareholders' agreements. Shareholders can agree a call option over the stake of anyone who leaves the company, or a put option allowing a minority shareholder to sell to the majority under certain conditions. Such clauses prevent deadlocks and valuation disputes.

What to watch out for

Writing, that is selling, options is far riskier than buying them. The writer receives a premium, but its loss from an adverse price move can be very large. Companies without a specialised treasury function should not write options to earn extra income.

Options have accounting and tax consequences. Derivatives are measured at fair value at the reporting date, and employee options may create taxable employment income on exercise. Before launching a plan or entering a hedging transaction we recommend consulting a tax adviser and an auditor.