You may have heard about employees offering stock options as part of the compensation. They are financial instruments that allow you to purchase or sell a particular stock for a specified price and at a pre-decided time. It is possible to purchase stock options or receive them through the employer as compensation. Before you engage in options trading, you need to understand how it works and how you can do it so that you do not miss a chance of making money.
What are stock options?
Stock options are unique types of financial market instruments that allow you to purchase or sell stocks at your time and pricing. This price is called the strike price. The time within which you can take benefit of the stock option will be based on the terms of the options. You can write the options on assets apart from stocks like commodities including metals or grains.
If there is a capped option, it will be automatically exercised when the share price reaches a specific level and will cap the amount of money you generate from the exercise of the option.
Let us take a look at the different types of stock options.
Types of Stock options
Call and put options
An option is a type of derivative because its price depends on another asset. The intrinsic value of an option is linked to the price of something else. Hence, when you purchase an options contract, you gain the right as an option holder but not an obligation to buy or sell at a price before the option’s expiration.
Options that allow you to purchase stock are known as a call option because you can call for the delivery of the specific stock at the strike price. The ones that allow you to sell the stock at a specific price are known as a put option.
Example of a call option
You see the development in your neighborhood and are keen on buying a home. But you will only exercise this right after you are certain that the developments around the area are complete.
Now if you buy a call option from the developer at $200,000 to purchase a home over the next 3 years, the developer will not grant this right for free. You will have to make a downpayment to lock in the right. This is known as option premium.
Now if you decide to purchase a home in 2 years, you only pay $200,000 because the price was fixed. Even if the market value of the home is $400,000, you only pay the pre-decided amount. In another scenario, if you do not exercise your right to purchase the home in the 3 years, the contract has expired and you will have to pay $400,000 while the developer keeps the down payment.
Let us look at it in the form of shares. You purchase a call option for Apple (AAPL) stock
at $150 a share and you think it will go up to $155. As an option buyer, you get the right to buy the shares at $150 instead of $155. Now because you are only buying an option to buy them, you are under no obligation to buy the shares if the stock price does not go up as you expected it to.
Example of a put option
You buy a put option on Apple (APPL) stock at the strike price of $125 per share. You expect the stock to go down to $110 per share in the next 6 months. It will allow you to make a decent profit by exercising the option when you sell the shares at a higher price than the market rate. Now, if the stock market shows volatility and the stock price falls, you can sell it at the strike price and take home the money. Options are ideal when the market seems bearish.
A call option value will rise if it is likely that the price of the stock will be higher than the strike price when they are supposed to be exercised. Hence, you can buy the stock at a good bargain price.
A put option will increase in value whenever the stock price is expected to be below the strike price. This will allow the holder to sell their stock for a price that is higher than the one prevailing in the open market.
Trading in stock options
It is possible to purchase or sell the stock option through a stock brokerage or online brokerage. They will provide details on how you can do so. As per the Securities and Exchange Commission rules, it is important to fill the application with the brokerage before you start to trade-in options. You will have to provide details about your income, finances, as well as net worth. You will also have to specify the type of options you want to trade and your long-term investment goals. The brokerage will then assign you the risk category and will define the type of options trading strategies you can enter into.
Keep in mind that some options will be cash-settled, which means you only receive the difference in the strike price and stock price when you make money on the option instead of buying and selling the actual stock.
You will also come across the concept of an option being in, at, or out of money. This is an important concept you need to know. When the option is said to be in the money, it will make money based on the current price of the stock. It means the stock price is higher than the strike price in the case of a call option and the stock price is lower than the strike price in a put option. An option is at the money when the strike price and stock price are equal. The option will be out of money when the strike price is higher than the market price and you have to pay higher to purchase the stock.
The purchase or sale of options involves another party agreeing to buy the security or deliver the security and it carries the risk of losing all the money. If the exercise date is here and the option is out of money, it will be useless.
It is also possible to write or create your options. It will allow others the right to purchase the stock from you or sell it to you at a price you have agreed on. When you write the call option which you do not own, it is known as writing a naked or uncovered call. It is riskier to write options as compared to buying them. If you bet in a particular direction and the stock is headed in the opposite direction, you could lose your money.
Employee stock options
There is growing awareness of employee stock options across the globe. Companies offer stock options to employees in addition to their salary and bonus. It allows the employees a right to buy the stock at a certain price on a certain date. It is usually based on the price when they start working with the company. They are similar to call options but you cannot sell them.
Employee stock options work in the favour of employees and companies use them to attract prospective employees or to retain current employees. If you join the company and the stock price rises, the options will allow you to buy the stock at a bargain price. However, you will be taxed on the price difference between the market value and the strike price when you exercise the option. The discount is compensation from the employer.
There are some stock options which are incentive stock options. In these, you are allowed to pay an income tax at the long-term capital gain rate instead of the regular rate of income tax. It will help save money. If the employee stock options do not adhere to the legal requirements, they will be considered as non-qualified stock options.
Understanding employee stock options
The main purpose of stock options for an employee is to own the company’s stock at a discount as compared to purchasing it from the stock market. However, it is important to understand how incentive stock options work. The retention of an employee who has stock options will occur through vesting. It allows the employers to encourage their employees to stay through a specific period known as the vesting period to get the shares. The vesting period can range from three years to five years.
This means the options do not belong to the employee until the requirement of vesting has been met. Let us take an example to understand better. You have been granted 8,000 shares over a 4-year vesting schedule at 2,000 shares each year. Now this means that you need to stay for at least one full year to get the first lot of 2,000 shares and you must stay until the end of four years to exercise the entire 8,000 shares. To get the full grant, it is important to stay with the company for the entire vesting period.
Exercising the stock option
Keep in mind that you cannot exercise the options till they are vested. There is a time limit associated with the exercise and if you want to sell them, you need to keep the expiration date in mind. If you are laid off before you get the options, or if the company is purchased by another company, you will lose the right to unvested options.
After the options vest, you can exercise them which means you can buy the shares of the company stock. The options do not have any value until you exercise. The amount you will pay for the options will be set in the contract that you signed when you started the job. It is known as the strike price or the exercise price. This price remains constant and will not change even if the company performs poorly. After you exercise, you own the stock and you are free to sell it. Remember that you will have to pay the fees, commission, or taxes that come with exercising and selling the options.
It is possible to exercise without putting up the cash to buy all the options. It is known as a cashless exercise. You can consider an exercise and sell transaction where you purchase the options and sell them immediately. The brokerage will handle the sale for you and the money made from the sale will cover the cost you incurred for the purchase.
You can also exercise through the exercise and sell to cover. Here, you just sell enough shares to cover the cost of purchase and you hold the rest. You can also sell the shares at the market price so you do not expose the stock to any volatility. In that case, you do not need to come up with the cash for transaction-related costs.
The options will have an expiration date and it will be in your options contract. They usually have 10 years or expire 90 days after you leave the company.
Estimating the value of your stock options
You can use a simple method to know the value of your stock options. When you own stock worth $25 per share and the strike price is $15, then the options will be $10 each. It will be hard to figure out the exact worth of the options if the company is pre-IPO. The value of the stock options depends on the strike price. Keep in mind that options have less value unless the market value exceeds the exercise price.
Taxation of stock options
Companies provide two types of stock options – Incentive stock options and non-statutory stock options. Its difference lies in the method of taxation. When you have an NSO, there will be a tax liability at the time of exercising the options which is the difference in the market value and exercise price. In the case of sales, the additional gain will be your long-term capital gain.
In contrast, ISOs will not be taxed right away. You will be taxed when you sell the shares. But to qualify for consideration as capital gains tax in the tax return, it is important to hold them for at least two years from the grant date and one year from the date of exercise. Those who do not meet these criteria will have to pay long-term capital gains tax at the time of sale.
The bottom line
Stock options are a common way for companies to attract and compensate employees. But they are not as straightforward as your paycheck and they have the potential to generate huge returns. The terms of the options will be set by the company and will be in your option contract. The contract will have all the details about the vesting period, strike price, and set price. Be aware of the terms of the contract and keep the expiration date in mind when you sell the shares.