Value

• Stock options are valuable when the price of the stock they provide an option to purchase rises above the exercise price---or strike price. The holder of the options may then buy the stock at the exercise price and sell it at a higher price. Imagine, for example, that in 2005 an employee was given a five-year option of XYZ company at $45 per share. In 2010, company XYZ is trading at $120, but the employee has the option to buy the stock at $45. The employee may exercise the option, purchase the stock at $45 a share and sell it for $120. The difference between $45 and $120 is the profit, assuming there are no commissions.
  
  

Revaluation

• Companies sometimes revalue the price at which the options may be exercised. This may happen, for example, when a company's stock price has fallen below the original exercise price. Companies revalue the exercise price as a way to retain their employees.
  
  

Option Changes

• The prices of stock options are not necessarily stagnant. A stock split may change the price. Companies also have the option to change the exercise price of the stock option if the value of the stock falls below the current exercise price.
  
  

Upside and Downside

• When stock options are part of your contractual compensation, there is an upside and a downside. If your agreed upon compensation is $120,000, including $20,000 in stock options, the stock price rises and you purchase it at the exercise price and resell it for a profit---as in the scenario above---that's the upside.
  If the stock does not rise to the exercise price, however, or falls, you may never be able to gain anything. For example if the same XYZ stock went from $45 to $40 in the five-year period and stayed below $45 and the option expired, you would never receive any benefit for having that portion of your compensation in options. That's the downside.
  
  

Stock Option as Bonus

• A young, private company whose management envisions taking the company public may award stock options to employees over and above contractual salaries as companions to or in lieu of cash bonuses.
  
  

Drawbacks

• Employee stock options also have limitations that are unlike owning a stock outright. A stock option cannot be hedged and it cannot be sold short. The reason for this is that hedging and selling short is taking a position that is bearish and is stating that the company will go down, which is against SEC regulations. Additionally, when an employee leaves a company voluntarily options are forfeited and all value is lost.