Key Takeaways

  • A stock option gives the holder the right (not obligation) to buy or sell shares at a preset price before the expiration date.
  • The two primary types of stock options are call options and put options, each used based on whether you expect the stock to rise or fall.
  • Key stock option terms include strike price, premium, expiration date, and contract multiplier.
  • Companies use stock options as incentives for employees and executives, aligning their interests with the company’s success.
  • Stock options can be qualified (ISOs) or non-qualified (NSOs), each with different tax implications.
  • The vesting schedule determines when options can be exercised, and early exercise provisions may apply.
  • Risks include losing the premium, options expiring worthless, and tax consequences if not managed properly.

What are Stock Options?

Stock options are benefits exchanged between two parties that provide the recipient the option to purchase or sell a stock at a previously agreed price across a designated period of time. Stock options in America are eligible for purchase or sale any time after the purchase date and any time before the option expires. European options or “share options” are much less popular than U.S. options and can be redeemed all the way up to the expiration date of the option.

Stock options are binding contracts that have both parties' consent and typically represent 100 shares of an underlying stock.

What Is a Stock Option Used For?

Stock options are widely used for both compensation and investment purposes. For employees, they serve as a tool to align personal performance with the company's growth. In investing, traders use stock options to speculate on price changes, hedge risk, or enhance portfolio strategies. Some common uses include:

  • Employee Incentives: To retain and motivate staff through potential future gains.
  • Portfolio Hedging: To protect against losses by locking in prices.
  • Speculative Trading: To leverage capital and profit from market volatility.

Option Type – Put and Call Options

Stock options take into account a name when a purchaser enters into a contract to buy stock at a selected value by a selected date. An option is taken into account when the option purchaser takes out a contract to sell a stock at an agreed-on price on or earlier than a selected date. The idea is that the purchaser of a stock option believes that the underlying stock will increase, while the seller of the option chooses in any other case. The option holder has the advantage of buying the stock at a discount from its present market value if the stock value will increase before expiration.

If, however, the purchaser believes a stock will decline in value, he enters into an option contract that provides him the right to sell the stock at a future date. If the original stock loses its value before expiration, the option holder is able to sell it for a premium from the current market worth.

How Exercising a Stock Option Works

Exercising a stock option means choosing to buy (call) or sell (put) the underlying asset at the strike price. The process can differ based on the type of option:

  • American-style options allow exercising any time before expiration.
  • European-style options restrict exercise to the expiration date.
    For employee stock options, exercise is only possible after they vest. Once vested, employees can purchase shares at the strike price, regardless of current market price. Some companies allow early exercise, which lets employees exercise before full vesting, typically with restrictions.

Strike Price

The strike price of an option is what dictates whether or not it is beneficial. When an option is finally exercised, meaning it is either sold or purchased, the price of the underlying asset at that time is known as the strike price. The strike price is directly related to the market price of the asset, and this relationship impacts the value of the option and the premium.

Premium

With regard to stock options, a premium is the price a buyer must pay the seller for the risk associated with carrying that obligation. Determining the exact price of the option premium will take a lot of things into consideration like the volatility of the underlying asset, the strike price of the option, and how long is left until the option expires.

Risks of Stock Options

While stock options can offer significant rewards, they also carry risks:

  • Expiration without value: If the market price is unfavorable, the option may expire worthless.
  • Tax consequences: Improper timing of exercise can trigger high tax liabilities.
  • Dilution: Issuing new shares through stock options may dilute existing shareholders' equity.
  • Market volatility: Fluctuations in stock prices can make it difficult to predict profitability.

Expiration Date

All options have a definitive end date that is part of the value. After an option has reached its expiration date, the value of that stock option ceases. Within an option’s contract, you will find the exact month it is set to expire. The specific option type can also impact its expiration date. For example, U.S. stock options are set to expire on the third Friday of their expiration month.

Option Style

American and European style are the two types of styles used to describe option contracts. The method during which options might be exercised additionally depends upon the model of choice. You can exercise an American style any time prior to the expiration date, whereas European styles can be exercised only on the exact date they are set to expire. Any stock option you see being traded in the market is an American style.

Underlying Asset

Every option has a security that is delivered when a stock option is exercised, this is known as the underlying asset of the stock option. As it relates to options, this security or underlying asset is a company’s shares. There are many other types of underlying assets for options like commodities or currencies.

Contract Multiplier

If a stock option is exercised, the underlying assets need to be delivered to the option holder. If this occurs, to calculate the amount of underlying assets — or shares for stock options — that need to be delivered, we use a contract multiplier. Stock options cover 100 shares of the company.

Vesting Schedule and Cliff Period

Employee stock options follow a vesting schedule, which dictates when options become exercisable. Common schedules include:

  • Four-year vesting with a one-year cliff: No options vest during the first year. After one year, 25% vest, with the remainder vesting monthly or quarterly over the next three years.
  • Graded vesting: Options vest gradually over a period (e.g., 20% annually for five years).
    The vesting schedule incentivizes long-term retention and prevents immediate cash-out by new hires.

Why Do Companies Issue Stock Options?

Companies use stock options to draw and retain gifted workers. This is usually a cost-effective employee profit plan, in lieu of more money compensation.

Tax Implications of Stock Options

Tax treatment depends on the type of option and timing of exercise:

  • ISOs: If holding requirements are met, the gain may be taxed at the long-term capital gains rate. If not, it becomes a disqualifying disposition, taxed as regular income.
  • NSOs: Upon exercise, the difference between the strike price and market value is taxed as ordinary income, regardless of when the shares are sold.
    Additional considerations:
  • Alternative Minimum Tax (AMT) may apply to ISOs.
  • Capital gains taxes are triggered upon sale of the acquired shares.

Types of Stock Options Offered by Employers

Companies typically offer two main types of stock options to employees:

  • Incentive Stock Options (ISOs): These are often reserved for key employees and may offer favorable tax treatment if specific conditions are met. Gains from ISOs are usually taxed as capital gains if held long enough.
  • Non-Qualified Stock Options (NSOs or NQSOs): These are more commonly offered and do not require the same holding periods as ISOs. However, the difference between the exercise price and the market value at exercise is taxed as ordinary income.

Frequently Asked Questions

  1. What is a stock option in simple terms?
    A stock option is a contract that gives you the right to buy or sell a stock at a specific price before a set expiration date.
  2. How do employee stock options work?
    Employees are granted options that vest over time. Once vested, they can buy company shares at a fixed price, potentially profiting if the market value is higher.
  3. What happens if I don’t exercise my options?
    If not exercised by the expiration date, the options expire and become worthless.
  4. Are stock options taxable?
    Yes, depending on the type (ISO or NSO), taxation can occur at grant, exercise, or sale. Consult a tax advisor for your specific situation.
  5. Can I sell my stock options?
    Usually, employee stock options cannot be sold. Publicly traded options can be bought and sold on the open market.

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