Exercising Stock Options

As the stock options gain more ground as part of the employee compensation package, questions about what stock options are and what exercising stock options means are getting more and more common.

Employee Stock Options

If the company you work for has a stock options policy for its employees, that means that your company gives employees the option to buy stocks of the company.

Stock options, like the name tells you, is the option given by the company to the employees to own a part of the company. Why would one buy stock of the company he's working for? Because, usually, the stock options are offered at a price which is significantly lower than the stock market price and hence, it is a profitable proposition for you, if you choose to sell.

Now suppose the market price of the shares of your company is $10, your company will, for your good performance on the job and as part of your compensation package, offer you an opportunity to buy (exercise) the stock of the company at a price which is less than the market price. So the price which the employees can buy the shares of the company - known as grant price - is significantly lower than the market price. Let us assume that the grant price is $5. Now if you decide to buy 100 shares at the grant price and sell them off immediately at the market price, you have a chance to earn yourself a pretty penny. Your expense will be $500 ($5 X 100 shares) while your income from the sale of shares if $1000 ($10 X 100 shares), so in this transaction, you stand a chance to pocket $500 upfront! And if you expect the share price to go up after a year to $20, you can sell the shares at $2000 ($20 X 100 shares) so your profit is again very high.

Buying Stock

A stock option means an option to buy. So exercising stock options means exercising your option to buy the shares of the company.

• Grant Price: The grant price is the price at which the shares are sold to the employees of the company. The grant price, when fixed is supposed to be less than the market price. So if you buy the shares at a time when the grant price is less than the market price, then you have a chance on making a profit on an immediate sale, as outlined in the above given example.
• Vesting Period: The vesting period is the period over which you choose to sell your stock options. Some people may choose to sell them all at once and make a quick profit, if it is available. Others may choose to sell a part of the stock and keep a few shares for later if they feel that there is a chance that the stock price may rise in the future.
• When to Exercise Stock Options: When to buy the stock? You ideally ought to buy the stock when the difference between the grant price and the market price is the highest, the market price being the higher one. This way you end up buying the stock a lot cheaper and if you wish to sell immediately, you have a higher chance of gaining profit. On the other hand, financial difficulty may also force your hand in exercising stock options, irrespective of the market conditions.

Tax Implications:

Well that really depends on the type of stock options on offer. The first type is the Incentive Stock Option (ISO). Exercising stock options for an ISO will charge you nothing, but gains (if any) from the sale of these shares will be charged on the long term capital gains tax rate as is applicable in your country. If your stock is of the Non Qualified Stock Options (NQSO) type, then you will be charged income tax on the saving you make on the purchase (market price - grant price). The income tax rate depends on which tax bracket you fall under as overseen by the IRS. Plus, you will be paying the long term capital gains tax as specified above on the sale of stock.

Of course these rules for tax deductions differ from country to country and are subject to change, so it is always good to check with a qualified tax adviser who can review your individual situation, and guide you accordingly.

As you can see, stock options, if used properly can be a good source of income. Hence, it is very important that you know how to exercise them.