What does stock options mean

Most options are granted on publicly traded stock, but it is possible for privately held companies to design similar plans using their own pricing methods. Usually the strike price is equal to the stock's market value at the time the option is granted but not always. It can be lower or higher than that, depending on the type of option. In the case of private company options, the strike price is often based on the price of shares at the company's most recent funding round.

Employees profit if they can sell their stock for more than they paid at exercise. Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised. With some option grants, all shares vest after just one year. This is known as staggered, or "phased," vesting. Most options are fully vested after the third or fourth year, according to a recent survey by consultants Watson Wyatt Worldwide.

Whenever the stock's market value is greater than the option price, the option is said to be "in the money. During times of stock market volatility, a company may reprice its options, allowing employees to exchange underwater options for ones that are in the money.

It may sound like cheating, but it's perfectly legal. Outside investors, however, generally frown upon the practice -- after all, they have no repricing opportunity when the value of their own shares drops. We're no longer maintaining this page. Getting a job Getting a job k s k s: Starting to invest k s: Early withdrawals and loans k s: Rollovers k s: Retirement distributions Taxes Taxes you owe Income tax penalties The Alternative Minimum Tax Tax audits Health insurance Choosing a plan Where to buy coverage Finding affordable coverage Employee stock options Employee stock options Employee stock option plans Exercising stock options.

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Getting started Goals Setting financial goals. Banking Opening a bank account. Alternatives to traditional banks. Money market deposit accounts and CDs. Spending Making a budget. Debt Paying off debt. Generally, when you exercise NSOs, your employer will withhold taxes: federal and state income tax, Social Security, and Medicare. In order to pay the taxes associated with the exercise, employees may receive fewer shares.

When you sell the shares, whether immediately or after holding onto them, the proceeds will be taxed according to capital gains rules. ISOs, on the other hand, qualify for special tax treatment. Moreover, if held for more than two years from the grant date and one year from the date of exercise, ISOs qualify for the favorable long-term capital gains tax rates.

AMT runs parallel to the regular tax system, and taxpayers calculate both types of tax when figuring out how much tax they will ultimately owe. Whichever calculation yields the higher tax liability will determine the taxes owed. The alternative minimum tax is designed to help ensure that high earners pay at least a minimum amount of federal income tax. Without getting into the weeds of the AMT calculation, certain credits and deductions awarded under the regular tax calculation are added back to your AMT liability.

Although ISOs' bargain element is not recognized as taxable income at exercise, it is recognized as taxable income under the AMT calculation. There are key factors determining whether or not you will pay AMT, such as the number of ISOs exercised and the total bargain element.

Considering this, it may be worth it to calculate the number of ISOs exercisable without triggering the higher AMT liability. Taking a smart approach to stock options involves thinking about your whole financial picture and identifying the goals you have for your money. What do you want to do with the proceeds from the eventual sale of the stock? Understand what you want and need out of life, and then figure out how stock options can play a role in achieving those goals, whether it's starting a business, creating a nest egg, or providing meaningful experiences for yourself and your family.

Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.

If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees.

The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price. If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price.

It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line. ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule. As mentioned earlier, we had assumed that the ESOs have a term of 10 years.

This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up.

It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of. We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The following points need to be borne in mind with regard to ESO taxation:.

This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value.

The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.

The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant.

While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them. To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.

From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost.

The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money i. It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.

Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time.

LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration. Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement.

Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration.

With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices.

If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm.

If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration.

While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. For all listed options in the U. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday.

Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own shares through the automatic exercise feature. Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short shares through the automatic exercise feature.

Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration.

With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options. With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices. In the mids, an options backdating scandal in the U.

This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder.

Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days. Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer.

As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions. However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested.

This can pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining. As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs.

With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock.

You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock.