Incentive that can yield instant profit

The most basic form of share option is a contract to buy shares in a company at a future date, at a price agreed in advance. They are widely used as an incentive both for employees and directors.

If the shares in the company fall below the exercise price the options are worthless, but this costs the holder nothing. The options are simply ignored. If they rise above the exercise price, it makes sense to buy the shares, although normally this cannot be done for at least three years.

The great majority of shares bought as a result of option agreements are sold immediately to repay the money used to buy them. The difference between option and market price represents an instant profit.

Although many employees have share options provided by their companies, there are a number of special schemes for directors. The Government long ago accepted the argument that a stake in the company is a good incentive because it aligns the interests of executives with shareholders.

Under an approved executive share option scheme, there are tax benefits because the profit is treated as a capital gain, with an annual tax relief of more than £5,800. Those who keep their shares after exercising the option pay no gains tax until the shares are sold.

The drawback of options is that they often reward directors for a rise in the stock market rather than their own or their company's performance.