Your Complete Guide to Stock Options

July 29, 2022, 2:07 PM

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Stock options offer employees a chance to own a piece of the companies they work for — and maybe even make a nice financial gain if the company’s share price rises in value. Options are granted for many reasons, ranging from rewarding employees with stellar performance to attracting and retaining standout applicants.

Employee stock options are not shares of an actual stock. Rather, they are contracts that give employees the right to buy a specific number of shares of company stock at a specified price within a specified time frame. They often come with restrictions as to when they can be used, and many also include tax provisions.

Some employees of companies like Facebook and Google became millionaires thanks to stock options. Although stock options don’t guarantee you’ll earn a fortune, they could result in a big payoff with little risk if you work for a company that sees its share price skyrocket.

Stock options on publicly traded companies are a bit different than those offered to employees, because 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 flavors, “calls” and “puts,” which are essentially bets that a stock will either go up or go down, respectively.

Here’s a closer look at 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 shares of company stock at a pre-set price over a certain period of time, called the exercise period. The price is also referred to as the strike, grant or exercise price. Most options are granted on publicly traded stocks, but some privately held companies also offer stock option plans using their own pricing methods.

Publicly traded options share many of the same basic characteristics of employee options, but they must be bought or sold on an exchange, much like a stock.

Stock Option Basics Explained

One of the first things you’ll need to understand before making any decisions about stock options is how the equity grant agreement works. This is the document outlining how your company will award equity compensation. It will include 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’ll pay to buy the options.

  • The type of options granted. These will either be incentive stock options — ISOs — or nonqualified stock options — NSOs.

  • The vesting schedule, which lets you know when you can gain rights to your grant. This can happen incrementally over time, all at once, or on a time- or performance-based schedule.

  • The exercise window, which is the time period when employees can exercise options — usually 7 to 10 years.

  • The expiration date, or the date an option contract expires and can no longer be exercised.

  • The impact certain events have on vesting, such as the termination of employment or a change of control at the company.

Publicly traded stock options share some of the same features as employee options, such as a strike price and an expiration date, but terms like “grant date” and “vesting schedule” don’t apply to them since they can be bought and sold at any time on the open market.

What Are Some Stock Option Examples?

Suppose you have been at the company several years and are fully vested 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 an option’s strike price — in this case, $50 less $40 — is the actual value you’ll receive.

You can then either keep the stock if you think it will go higher, or sell it and take your profit. In some cases, you can even sell enough of the stock to pay off the cost of the option. But even if the value of the stock never gets above the strike price, you haven’t lost any money because you never paid for the option that was granted to you.

As an employee, stock options are a great deal because you are essentially being handed a no-lose promissory note. If the options you’re granted don’t gain in value, you haven’t lost any money because you haven’t invested any. But if your company shares become more valuable, your options will rise in price as well, sometimes dramatically, giving you all of the upside with none of the downside.

Investors who buy options on the open market, on the other hand, are taking on a potentially significant amount of risk. As there is a time component to options, investors who buy them can lose 100% of their investment, even if the stock underlying the options doesn’t go down in value. On the other hand, a stock option offers a leveraged way to play the price movement of a stock either up or down, as a small investment could translate into a large percentage gain. Options can also be used to hedge existing stock positions, by making a small leveraged wager that the stock will go down. This way, investors can still earn gains if the stock rises but are hedged against moves downward by their option position.

How Are Stock Options Taxed?

ESOs come in two types: incentive stock options and non-qualified stock options. Each is taxed differently. For both types of options, there’s no tax consequence to the employee at the time of the grant.

With an ISO, there’s no tax impact when you exercise it. But with an NSO, the difference between the exercise 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’re immediately liable for $10 per share of ordinary income. If you continue to hold the stock, its eventual sale will be taxed as a capital gain.

For ISOs, tax is only paid upon the sale of the acquired stock, and the gain on the sale of the stock is taxed at the capital gains rate if it has been held longer than one year after exercise and the grant date is at least two years prior. Unlike NSOs, a $10 per share gain would be taxed as a capital gain, rather than as ordinary income.

Investors who buy and sell options on the open market pay taxes on them in the same way as if they were shares of stock. However, as most options are short-term in nature, options trading typically results in short-term capital gains or losses, meaning they are taxed as ordinary income.

As of 2022, for assets held more than a year, capital gains are taxed between 0% and 20%, depending on your income. For most taxpayers, the tax rate on long-term capital gains is 15% or less.

The Bottom Line

Employee stock options are a great way to participate in the growth of your company because they are granted by employers and offer the potential of upside 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 off the short-term movements in a stock without having to lay out large sums of money. You’ll need to have a high risk tolerance and a speculator’s mentality to profit off market-bought options, but for some investors, they offer a great way to earn short-term gains or to hedge their investments.

Stock Options FAQ

Here are the answers to some of the most frequently asked questions about stock options.

  • When are stock options vested?

    • With some option grants, all shares vest after just one year. With most, however, some sort of graduated vesting scheme comes into play. For example, 20% of the total shares are exercisable after one year, and 20% after two years and continuing.

  • What are the main benefits of stock options?

    • The benefits of employee stock options typically outweigh the potential drawbacks. One of the main benefits is that options are offered as a form of compensation, at no cost to the employee when they are granted. Another benefit is that there is no tax to the employee to exercise ISOs. Finally, stock options give you the opportunity to participate in the growth of a company.

  • What are the main drawbacks of stock options?

    • Although stock options are meant as a reward, be aware of potential drawbacks. One is that ordinary income taxation applies when you exercise an NSO. Another is that if the valuation of the company’s stock price declines, so does the value of its options.

John Csiszar contributed to the 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