You’ve been granted stock options by your employer… Congratulations! Employee stock options can be a fantastic addition to your wealth-building strategy. Now what do you do with this stuff? Let’s start with the basics… 

Stock options are a form of compensation tied to the performance of a company’s stock. A stock option grants an employee the option (not required) to purchase company shares at a specific price in the future.

The strike price (aka exercise price) is the price at which you can purchase shares in the future. If the company’s market price rises above the strike price, you can exercise your options — buy the shares at the strike price.

If the current market price of the stock is above the strike price, the option is “in the money.” If the current market price of the stock is below the strike price, the option is “out of the money” or “underwater.”

Let’s look at two scenarios:

Scenario 1: “in the money”

Shares Granted: 10,000

Strike Price: $10

Current Market Price: $12

Option Value: 10,000 x ($12 – $10) = $20,000

Scenario 2: “out of the money”

Shares Granted: 10,000

Strike Price: $10

Current Market Price: $8

Option Value: Zero (underwater)

An employee stock option cannot have negative value. If the market price falls below the strike price, the option is considered “underwater.”

Exercise

If you work for a private company, exercising options likely requires you to use cash to purchase shares — ie you write a check for the total amount you want to exercise (strike price x the total number of shares).

In the case of a publicly traded company, the brokerage firm may allow you to perform a “cashless exercise.” The brokerage firm essentially issues you a very short-term loan, exercises your options (purchases stock in your account with the loaned cash), and then immediately sells those shares in the open market. The loan principal goes back to the broker, and the profit made from the sale is deposited into your account as cash.

Once you exercise options, you own company shares. A profit is not realized until the shares are sold.

Expiration

It’s very important to know that most option grants have an expiration date. If you do not exercise your options before the expiration date, they will expire worthless. Always make sure you’re aware of the expiration date of any option grants you’ve received.

Investment Return Profile

Employee stock options are only profitable when they are “in the money” — the market price rises above the strike price. If the market price falls below the strike price, you would not exercise your options.

The main forces driving the value of your options are the option expiration date and the volatility (fluctuations) of the stock price.

Let’s look at an example:

• you have vested stock options with a strike price of $20
• current market price is $15
• market price has stabilized over the past 3 months (low volatility)
• options are approaching their expiration date in 30 days 

Based on these circumstances, your options have a low value. There is a low probability that your options will be “in the money” before reaching the expiration date. In other words, it’s unlikely that the stock price will rise above the $20 strike price, allowing you to exercise and sell for a profit.

In contrast, shares received via an RSU vesting round or shares purchased by an ESPP have immediate value — you receive shares of the company upon vesting. After receiving shares, you’re exposed to the upward and downward movements of the stock price. Learn more about the differences between RSUs and stock options in this blog post.

Why is my employer giving me stock options?

You may be thinking… “Why would my company give me stock options instead of paying me a cash bonus?” There are a few reasons: 

1. The company wants to align your interests as the employee with the interests of shareholders (owners). Since you are now a shareholder and partial owner, your decision-making, choice of projects, quality of work, motivation, etc. should promote long-term appreciation in the stock price. 
2. The company wants you to stick around. Most stock option grants are subject to a vesting schedule tied to length of employment. For example: 25% of your option grant vests (you can exercise it) every year after the grant date. If you want to leave your current employer for another job, you’ll have to give up all of your unvested shares. High turnover is expensive for companies — finding and training your replacement takes resources and time. Companies can use employee stock options and RSUs to prevent you from leaving.

There are two main types of employee stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The type of option you have will result in various tax consequences upon exercise and sale. If you have specific questions about the tax impact of your employee stock options, speak with a CPA or qualified financial professional.