Many employees hold stock options, but are unfamiliar with what the investment instrument is or how it benefits them financially. An employee stock option provides its holder with the option, not obligation, to purchase a given security at a specified price, within a specified time frame. Stock options are most commonly used as a method of compensation for valued employees.
Stock Option Terminology
Before we dive into how to leverage stock options within your portfolio to build wealth, it is important to gain a thorough understanding of basic terminology. First, one of the most important components to a stock option is its vesting period. A vesting period is the restricted period for the underlying stock option, or the waiting period the employee must satisfy before exercising their option. A vested stock option describes shares that are available to purchase. Most stock options are given to employees with varying vesting schedules; some vesting annually over a number of future years. For example, an employee may be given 10,000 shares of stock, vesting 25% per year over the next 4 years.
Stock Options- When are they “In the Money”?
When does a stock option have inherent value? Stock options are thought to have value when the underlying stock rises above the noted option’s strike price. For example, if a stock option’s strike price is set at $30, and the stock is currently trading at $30, the option’s value is said to be $2. The greater the spread between the market price of the underlying stock and the stock option price, the greater the potential value to the employee. It is important to note that an option has no value until it is exercised.
Exercising Options- What’s Next?
Once the employee’s stock options have vested, if they are “in the money”, the employee has the option to exercise. The term exercising refers to the notice provided by the employee to the company of their intent to buy stock. Whenever the employee chooses to exercise their vested options, they must place a buy order. And immediately following their buy order, most place a sell order to capture gains offered on the underlying security.
For example, if an employee currently holds 1000 options of XYZ stock at $25, and the stock is currently trading at $40, the employee would purchase 1000 shares of XYZ at $25 and then immediately sell those same shares at market, yielding a $15 per share profit before taxes, or $15,000.
Many organizations offer the option to complete a cashless transaction, which is preferred by most investors. Those that do not offer this option will require the buyer to settle the transaction using a brokerage account with sufficient cash or margin. A cashless transaction enables both buy and sell side transactions to occur simultaneously without the investor being required to hold the $25,000 needed to purchase the security. Once the transaction settles, the investor will capture their $15,000 in gross profit. Either settlement option yields the same end result; the cashless option is simply more attractive to investors with limited liquidity.
Stock options represent the possibility of investment gains to the underlying holder. Investors must understand when their options move into the money so they can determine if and when they would like to exercise them.