A stock option gives the recipient the right, but not the obligation, to buy a named stock at a fixed price (called the exercise price) within a specified period of time.
Here is a fictitious example of how the process works. Rod Thomas is the chairman and CEO of BLAND Corp., a manufacturer of a patented anti-pollution device for passenger cars. As part of his compensation package, he receives 100,000 stock options "at the money" (meaning that the exercise price is equal to the market price) that do not expire for 10 years. These options give him the right to purchase 100,000 shares of BLAND stock at the then-current market price of $50 per share.
BLAND Corp. discloses the option award in a footnote to its financial statements as part of its annual report. There is no charge to reported earnings.
Thomas does not exercise his options right away because this would generate zero profit. He decides to wait.
One month later, Congress passes legislation mandating that all new cars come equipped with the type of anti-pollution device that BLAND manufactures. As a result, the company's stock triples in value to $150 per share.
Thomas exercises his option to buy 100,000 shares of BLAND stock for $50 per share. BLAND Corp. purchases 100,000 shares on the open market at the going price of $150 per share and sells them to Thomas at a loss of $100 per share, for a total loss to the corporation of $10 million.
Finally, Thomas realizes a capital gain of $10 million when he immediately resells the shares. BLAND Corp. recognizes the $10 million loss as a tax-deductible business expense. The market price of BLAND Corp. shares decline to $120 per share when corporate earnings fall short of analysts' forecasts, most of which failed to take Thomas's options into account.