SStock options offer employees the chance to own a portion of the companies they work for – and possibly even make a nice financial gain if the company’s stock price increases in value. Options are awarded for many reasons, ranging from rewarding employees with outstanding performance to attracting and retaining outstanding candidates.
Employee stock options are not real shares. Rather, they are contracts that give employees the right to purchase a specific number of company shares at a specified price within a specified time. They often come with restrictions on when they can be used, and many also include tax provisions.
Some employees of companies like Facebook and Google have become millionaires thanks to stock options. Although stock options don’t guarantee you’ll make a fortune, they could pay you big with little risk if you work for a company that sees its stock price skyrocket.
Stock options on publicly traded companies are a bit different from those offered to employees, as these types of options can be bought and sold on the open market, just like shares of a stock. Unlike employee options, open market options come in two forms, “calls” and “puts”, which are essentially bets on whether a stock will rise or fall, respectively.
Here is an overview of how stock options work.
What is a stock option?
An employee stock option is a right granted to you by your employer to buy or exercise a certain number of company shares at a predefined price over a certain period of time, called of exercise. The price is also referred to as the exercise price, grant price or exercise price. Most options are granted on publicly traded stocks, but some private companies also offer stock option plans using their own pricing methods.
Publicly traded options share many of the same basic characteristics as employee options, but they must be bought or sold on the exchange, much like a stock.
The Basics of Stock Options Explained
One of the first things you need to understand before making a stock option decision is how the capital allocation agreement works. This is the document outlining how your company will award equity compensation. It will contain important details, such as the following:
- The grant date, which is the date your stock options are granted to you.
- The number of options granted.
- The strike price, which is the price you will pay to buy the options.
- The type of options granted. These will be either incentive stock options – ISO – or non-qualified stock options – NSO.
- The vesting schedule, which lets you know when you can earn rights to your grant. This can happen gradually over time, all at once, or on a time- or performance-based schedule.
- The exercise window, which is the period during which employees can exercise options, usually 7 to 10 years.
- The expiration date, or the date on which an option contract expires and can no longer be exercised.
- The impact of certain events on the acquisition, such as termination of employment or a change of control within the company.
Publicly traded stock options share some of the same characteristics as employee options, such as a strike price and an expiration date, but terms like “grant date” and “schedule of acquisition” do not apply to them since they can be bought and sold at any time on the open market.
What are some examples of stock options?
Say you’ve been in the business for several years and are fully invested in your options, which were granted with a strike price of $40, and the stock is currently trading at $50 per share. Your option would be worth $10 per share if you were to exercise it. The difference between the current market value of a stock and the strike price of an option – in this case, $50 minus $40 – is the actual value you will receive.
You can then either hold the stock if you think it will go up, or sell it and take your profit. In some cases, you can even sell enough stock to pay off the cost of the option. But even if the value of the stock never exceeds the strike price, you haven’t lost any money because you never paid for the option you were granted.
As an employee, stock options are good business because you essentially receive a promissory note with no loss. If the options assigned to you do not increase in value, you have not lost money because you did not invest any. But if your company’s stock becomes more valuable, your options price will also rise, sometimes dramatically, giving you all the benefits without any of the downsides.
Investors who buy options on the open market, on the other hand, are taking on potentially significant risk. Because options have a time component, investors who buy them can lose 100% of their investment, even if the stock underlying the options does not lose value. On the other hand, a stock option offers a leveraged way to play the movement of a stock’s price up or down because a small investment can result in a percentage gain. important. Options can also be used to hedge existing stock positions, by making a small leveraged bet that the stock will go down. This way, investors can still make gains if the stock goes up, but are protected against downsides by their option position.
How are stock options taxed?
ESOs are of two types: incentive stock options and non-qualified stock options. Everyone is taxed differently. For both types of options, there are no tax consequences for the employee at the time of grant.
With an ISO, there is no tax impact when you exercise it. But with an NSO, the difference between the strike price and the current market price of the stock is taxable as ordinary income. For example, if you exercise the option at $40 and the stock trades at $50, you immediately owe $10 per common income share. If you continue to hold the stock, its eventual sale will be taxed as a capital gain.
For ISOs, tax is only paid when the acquired shares are sold, and the gain on the sale of the shares is taxed at the capital gains rate if it was held for more than a year after the financial year and that the grant date is at least two years previously. Unlike ONS, a gain of $10 per share would be taxed as a capital gain rather than ordinary income.
Investors who buy and sell options on the open market pay taxes on them in the same way as on stocks. However, since most options are short-term in nature, options trading generally results in short-term capital gains or losses, which means they are taxed as ordinary income.
From 2022, for assets held for more than one year, capital gains are taxed between 0% and 20%, depending on your income. For most taxpayers, the long-term capital gains tax rate is 15% or less.
Employee stock options are a great way to participate in the growth of your business because they are granted by employers and offer upside potential without having to risk your own capital. Market-bought options, however, involve risking up to 100% of your capital. But they also offer a way to make big profits on a stock’s short-term movements without having to shell out large sums of money. You’ll need to have a high risk tolerance and speculative mindset to profit from market-bought options, but for some investors they offer a great way to make short-term gains or hedge their investments.
Stock Options FAQs
- When do stock options vest?
- With some option grants, all shares vest after only one year. With most, however, some sort of progressive vesting system comes into play. For example, 20% of the total shares are exercisable after one year and 20% after two years and more.
- What are the main advantages of stock options?
- The advantages of employee stock options generally outweigh the potential disadvantages. One of the main advantages is that the options are offered in the form of compensation, at no cost to the employee when they are granted. Another advantage is that there is no tax for the employee to exercise the ISOs. Finally, stock options give you the opportunity to participate in the growth of a company.
- What are the main disadvantages of stock options?
- Although stock options are designed as a reward, be aware of the potential downsides. The first is that ordinary income tax applies when you exercise an NSO. Another is that if the valuation of the company’s stock price decreases, the value of its options also decreases.
John Csiszar contributed reporting for this article.
Information is accurate as of July 28, 2022.
This article originally appeared on GOBankingRates.com: Your Complete Guide to Stock Options
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.