What are Stock Options and How Do They Work?

What is a stock option?

A stock option is a financial instrument that allows the option holder the right to buy or sell shares of a certain stock at a specified price for a specified period of time.

Stock options are traded on exchanges much like the stocks (Apple, ExxonMobil, etc.) themselves. The price of the option itself can be higher or lower than the original price when it was first listed. Most listed options in the U.S. conform to an options calendar and typically expire on the third Friday of the month in which they are set to expire. Prior to this expiration date, the option holder has to decide whether to exercise the option by buying or selling the number of shares associated with the option, selling the option, or simply letting it expire.

In addition to listed stock options, a number of companies offer employee stocks options as a form of incentive compensation. Employee stock options offer the employee the right to purchase a set number of shares at a specified price for a fixed period of time.

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How do stock options work?

The price of a listed option is tied to the price movement of the underlying stock. If the price of the stock rises or falls, the option will generally move in the same direction.

Here are a few key terms associated with options:

  • A call option allows the option holder the right to purchase the stock at a set price within a set time.
  • A put option allows the buyer the option to sell shares of the stock at a set price within a set period of time.
  • The strike price is the price at which the option can be exercised.
  • A premium is the amount the buyer of the option pays for the option. It represents the maximum profit the seller of the option can realize. You can think of selling the option in the same way you’d think about selling shares of a given stock.

Unlike stocks, options trade as a contract, with one contract covering 100 shares of the underlying stock. The premium paid by an option buyer or received by an option seller has two parts, both of which affect the option’s premium:

  • The intrinsic value, which is the difference between the strike price of the option and the market price of the underlying stock
  • Time—both when the option expires and the volatility the underlying stock experiences during the period in which the option is held

A call option where the strike price is above the market price of the stock is considered “in the money.” A call option where the strike price is above the price of the stock is considered “out of the money.”

The bid price is the price that a buyer of the option is willing to pay. The ask price is the price that an option seller is willing to sell the option at. Note that since an option contract covers 100 shares of the underlying stock, the bid and ask prices must be multiplied by 100 to get to the price for an option contract.

Employee Stock Options

Employee stock options are not traded on an exchange but have some similarities to traded options. Here are some key ideas specific to employee stock options:

  • Grant date, which is the date on which employees are granted the options.
  • Vesting schedule, which is the time table under which the employees gain full control over the options. This can vary by company. The options may vest all at once or gradually over time, say 20% per year over a five-year period. Only the vested portion is eligible for exercise. (If you leave the company, vesting generally stops. There may be provisions regarding when any vested options must be exercised.)
  • The strike price, which is the price at which the shares may be purchased.
  • The expiration date, which is the date by which the options must be exercised. If the options are not exercised by this date, they expire, worthless.

The decision to exercise an option is similar to the decisions made by options traders. If the underlying stock’s price is above the strike price then it makes sense to exercise. If it’s below the strike price it doesn’t make economic sense, of course. Employee stock options come in two main varieties:

Non-qualified stock options: These are taxed as ordinary income in the year the options are exercised. The taxable amount is the difference between the price of the stock when the options are exercised and the grant price (strike price) of the options. One you exercise the options (as long as the stock is held for at least a year and a day), then any post-exercise gain is taxed at favorable long-term capital gains rates.

Incentive stock options: These are more complex in terms of their taxation. Employees could be liable for ordinary income taxes, long-term capital gains, and the alternative minimum tax in various combinations.

Stock options versus RSUs

Restricted stock units (RSU) are another form of stock-based compensation that companies can choose to provide to selected employees.

RSUs are a grant of a specific number of company shares. They are taxed when the shares are actually received, and the amount of taxable income is based on the market price of the shares when actually received.

RSUs typically have some sort of vesting schedule, if you leave the company for any reason, the vesting schedule ceases.

Unlike employee stock options, RSUs almost always have some sort of value. Even if the price of the stock declines from the time you are granted the RSUs, they will have value based on the stock’s market price at the time of vesting. With stock options, if the market value of the stock falls below the strike price, they are essentially worthless.

With an RSU you are essentially given the shares of stock, with the requirement you must actually purchase the shares. There are also tax differences: With an RSU, the value of the shares is considered income and taxed at the time of the grant. You also may incur capital gains taxes when you sell the shares, either long-term or short-term depending on your holding period.

What do you do if you’re granted employee stock options?

If you’re fortunate enough to be granted employee stock options, or RSUs, there are a number of things to do and consider:

1. Read the option agreement.

You should understand everything contained within your options agreement. This is both compensation and an investment option, be sure you are aware of the potential tax impact, as well as what you need to do to exercise the options. Consult a financial or tax professional for help if needed.

2. Understand how options fit into your financial plan.

Consider how this option grant and the underlying shares fit into your overall financial plan and your investment strategy. When exercising, be sure to consider whether the shares will make you over-allocated to your company’s stock. A concentrated position in any stock can be risky, this is especially the case with your employer’s stock. If the company encounters financial difficulties, the stock could fall, eroding a large portion of your net worth.

3. Commit to an investing strategy.

You will want to have a strategy perhaps that’s to buy, hold and sell the stock as part of your plan. Note that public companies have specific trading windows for when employees can buy and sell stock. You will also want to do any tax-planning around the options as appropriate. There are several options to consider around exercising the options:

  • A cashless exercise, if available, is where you exercise the options and sell the options almost immediately. The net proceeds from the sale are deposited in your brokerage account and you can then reinvest the money elsewhere. You may also be able to have the estimated taxes withheld as well.
  • A cashless hold is similar in that you exercise the options and then sell enough shares to cover the costs. You then hold the remaining shares for investment.
  • Letting the options expire, which is usually the best strategy if the market price of the stock is lower than the strike price. It makes no economic sense to exercise and then sell at a loss.

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