Stock options are financial contracts that allow the holder to lock in a purchase or sale price for an asset. Options have various uses in finance. One of the most common is as a form of executive compensation. Corporate executives are often granted options as an incentive to work harder. Spring loading is an ethically questionable practice used while granting executive stock options.
A call option locks in a purchase price, and a put option secures a sale price for a future transaction. Every option has an underlying asset, expiration date, strike price and quantity. The underlying security is what the option holder can buy or sell. The strike price is the price at which this transaction will occur if the option holder decides to engage in the transaction. The quantity is the amount of the asset that will change hands if the option is executed.
The options granted to corporate executives are always call options, allowing the executive to buy her company's stock. A typical executive option would look as follows: A manager working for Wal-Mart might may be granted a call option with Wal-Mart stock as the underlying asset, strike price $75, quantity 1,000 and expiration date of Jan. 2, 2015. On that date, the executive holding this option can purchase 1,000 shares at that price from Wal-Mart. If Wal-Mart stock is trading at less than $75 in the stock market, it's cheaper to buy the shares at prevailing market prices. The executive can ignore the option.
The higher the stock price, the more a call option is worth. If, for example, Wal-Mart stock is worth $80 on Jan. 2, 2015, the executive can purchase the stock at $75 from her employer and sell it at the prevailing market price of $80, pocketing a profit of $5 per share or $5,000 in total. If the stock climbs to $100, the per-share profit rises to $25 and the total profit climbs to $25,000. Therefore, executives who have stock options have an incentive to work harder. The harder they work, the more money the company makes, the higher the company's stock price climbs, and the more their options will be worth.
The strike price of executive stock options is usually the prevailing market price when the options have been granted. If the stock is trading at $80, the options granted at that time will usually allow the executive to buy the company stock on a future date at $80. "Spring-loading" is the practice of granting options to executives just before the stock is expected to appreciate. This virtually immediate gain in stock price translates into quick gains to the option holder. If the company had a great year and is about to announce stellar profits, it might grant options before the news is released and the stock price leaps. Spring loading is not illegal, but some critics say it allows executives to pocket quick and potentially excessive profits.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.