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Exercising Stock Options

S tock options are valuable benefits that some companies offer employees. One of the key factors with stock options is knowing if and when to exercise them, which takes a little research to make sure you get the most out of the stock. If you decide to exercise your stock options, you can take a few different routes, each of which has its own advantages and disadvantages.

Key Takeaways

  • Stock options allow you to purchase stock at a set price regardless of the current price.
  • Choices when exercising stock options require careful decision-making.
  • Nonqualified and incentive stock options have different tax implications.
  • Restrictions and terms vary depending on the company.
  • Stock options have similarities and differences with stock purchase plans, which allow investors to purchase stock at a discount.
  • Exchange-traded stock options cost investors money and have shorter durations.

What Are Stock Options?

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Stock options allow employees to purchase their employer’s stock at a set price, known as the grant price, option price, or strike price. The strike price is often the fair market price at the time that the employer offers it. Stock options do expire after a period of time and are of no value once they expire.

Holding stock options allows investors to time the market and maximize profit based on market fluctuations.

Investors can also hold stock options and decline to use them if stock performance doesn’t justify making a purchase. They don’t lose anything if they don’t exercise the option. Finding the best opportunity to exercise options includes timing the market, considering the share price, and knowing the tax implications.

Stock options are subject to rules set by employers. There are usually special rules in the event of separation, retirement, or death. Some employers may also select blackout dates around fiscal year-end, dividend schedules, and the end of the calendar year.

Stock options may even be exercised after termination from an employer, depending on the company’s policies.

Types of Stock Options

Stock options are becoming a popular benefit offered by employers. Employees can use these options to gain profit in addition to their salaries. Likewise, employers benefit because their employees have vested ownership in stock performance. Vesting schedules also encourage employee longevity. For example, a company may issue a five-year option grant with a one-year vesting period before stock options may be exercised. The actual exercise period, in this case, would be four years. Investors typically can determine how many shares to exercise and the timing during the exercise period.

There are two different types of stock options:

  • Nonqualified Stock Options: NSOs are more traditional stock options where employees are taxed when they exercise the options. The IRS levies ordinary income taxes, Social Security tax, and Medicare taxes on the difference between fair market value and grant price of the stock options.
  • Incentive Stock Options: ISOs are stock options that qualify for special tax breaks. ISOs aren’t taxed on the difference between fair market value and grant price as long as the investor holds the stock for at least a year after exercise and two years after the grant date. An early sale is subject to a capital gains tax. Ideally, investors should hold their shares for at least two years to avoid paying excessive amounts of taxes.

Exercising Stock Options: Your Choices

You have several choices when your company offers stock options depending on the terms and the expiration date of the options they grant. Consider tax implications carefully. Also, determine your willingness to take risks because you’re potentially placing a significant amount of money in one stock.

Be aware of your bias and familiarity with your company, and seek unbiased information about its fundamentals. Check out the latest news and press releases to gain up-to-date information. Research competitors as well. Consider who’s buying and selling the company’s stock and if there are current or upcoming programs for other employees to earn stock options or purchase stock through other programs.

Consider sales and profitability and whether or not the company is an acquisition target. Stock tends to spike for the company that’s the target of an acquisition, while the stock of an acquiring company tends to dip because it often pays a premium for the target company.

Use the information to help determine target prices to best exercise your options, including how much you want to buy. Set high and low share ranges to initiate buying or selling actions.

Here’s how to exercise stock options:

Hold the Stock Options

Investors can hold their options until they’re ready to exercise them, but they need to make sure to do so before the options expire. This allows investors to delay tax impacts and maximize the value of the options if the stock appreciates while holding the options.

Exercise periods could span several years, enabling a wide variety of choices depending on company fundamentals and the broader market’s performance. However, waiting too long to exercise the options means the employee could miss out on the highest prices, making research and timing crucial.

Exercise-and-Hold Transaction (Cash For Stock)

Exercising the stock options, purchasing the stock, and holding the stock are the strategies involved in an exercise-and-hold transaction (cash for stock). Investors need to pay the stock option cost, taxes, and brokerage commissions and fees. Many investors choose to hold onto stocks long term, giving them income, investment growth, and a sense of ownership.

Investors also collect dividends (if offered) and increase their investment as the stock goes up in value.

Exercise-and Sell-to-Cover

To execute an exercise-and-sell-to-cover transaction, investors exercise the stock options, purchasing the shares, and then sell just enough to cover the stock option cost, taxes, and brokerage commissions and fees. The proceeds from this transaction are stock and an amount of residual cash.

Investors collect dividends and increase their investment as the stock goes up in value. Purchasing the shares at a discount provides instant profit margins.

Exercise-and-Sell (Cashless)

To utilize an exercise-and-sell transaction (cashless), investors exercise the stock options and sell the acquired shares simultaneously without using cash. The proceeds are the fair market value minus the grant price. The profits are taxed and subject to brokerage commissions and fees.

Investors collect the cash and can use the proceeds for other investments. The transaction limits exposure to financial risk since the stock is bought and sold at the same time.

The exercise-and-sell transaction could be funded through a stock swap of shares of the company previously owned by the investor.

Similar Options

While stock options allow investors to exercise options at a set price, employee stock purchase plans give set discounts from the fair market value. Such plans can either be qualified or unqualified for special tax treatment. Stock purchase plans allow for long-term investing by purchasing stock regularly over time.

Exchange-traded stock options, or call options, must be purchased in less than two years. Stock options are more valuable since they typically have longer durations and are free of charge. Purchasers of exchange-traded stock options who see the stock value decline under the option price lose they paid if the stock doesn’t rebound. Brokers typically require special approval to purchase exchange-traded stock options due to the risks.

Exercising stock options is a reliable way to meet investment goals, whether they are long-term, high-risk, low-risk, or somewhere in the middle. Stock options vary depending on the company, as do the tax implications of the transactions. Wisely exercised stock options are an excellent investment tool that can fit diverse needs and goals. If your company has stock options, carefully research the details of this potentially lucrative offer.