What Are Stock Options and How Do They Work?
Stock options offer employees a chance to own a piece of the companies they work for – and maybe even make a nice financial haul if the company’s share price rises in value. Options are granted for many reasons, ranging from rewarding employees for stellar performances to attracting and retaining standout applicants.
Employee stock options, aka ESOs, 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.
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.
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 seven 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.
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.
How Are Stock Options Taxed?
ESOs come in two types: incentive stock options (ISOs) and non-qualified stock options (NSOs). 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.
As of 2021, 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.
Stock Options FAQHere 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.
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- Morningstar. 2021. "How Do Employee Stock Options Work?"
- CNN Money. "Employee Stock Options."
- CNBC. 2021. "Stock Trading Could Mean a Hefty Tax Bill. What You Need To Know."