An employee stock option is the right given to you by your employer to buy ("exercise") a certain number of shares of company stock at a pre-set price (the "grant," "strike," or "exercise price") over a certain period of time (the "exercise period").

Most options are granted on publicly traded stock, but it is possible for privately-held companies to design similar plans using their own pricing methods. Usually the strike price is equal to the stock's market value at the time the option is granted, but not always. It can be lower or higher than that, depending on the type of option.

Employees profit if they can sell their stock for more than they paid at exercise. NCEO estimates that employees covered by broadbased stock-option plans receive an amount equal to between 12% and 20% of their salaries from the "spread" between what they pay for their option stock and what they sell it for.

Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised." Restrictions inside this period are prescribed by a "vesting" schedule, which sets the minimum amount of time that must be met before exercise. With some option grants, all shares vest after just one year. With others, 20% of the total shares are exercisable after one year, another 20% after two years, and so on. This is known as "staggered" or "phased" vesting. Most options are fully vested after the third or fourth year, according to a recent survey by consultants Watson Wyatt Worldwide.

Whenever the stock's market value is greater than the option price, the option is said to be "in the money." Conversely, if the market value is less than the option price, the option is said to be "underwater."

During times of stock market volatility, a company may "reprice" its options, allowing employees to trade in underwater options for in-the-money options. For example, if options were originally exercisable at $50 and the stock's market price dropped to $30, the company could cancel the first option grant and issue new options, possibly fewer than originally granted, exercisable at the new $30 share price. Investors generally frown upon this practice, however, which may be why 85% of companies surveyed by consultants Towers Perrin after last fall's market swoon said they were not considering repricing, even though almost all had options that were then underwater.

Next: Types of options