How Do Stock Options Work?

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Stock Options

A stock option is the right to buy a certain number of shares of a company’s stock at a specific price, often referred to as a strike or exercise price. The option to purchase usually follows a specific period of waiting time that’s known as a vesting period. The vesting period is usually between three to five years, after which you’ve earned the right to purchase the stock at the strike price.

Stock options, also referred to as employee stock options, are often used as an incentive for attracting and retaining employees who might find buying options appealing.

What is a Call Option?

A call option is a contract between the buyer and seller that gives the buyer the right to buy a stock, commodity, or bond at a specific price on or before a certain date. If the stock price in the stock market rises above the strike price, then it makes sense to exercise the option to buy.

Related: 7 Tips You Need To Invest In Stocks The Right Way

What is a Put Option?

A put option gives someone the right to sell stock they own at a specified price on or before a set date. A put option becomes more valuable as the price of the stock you’re selling decreases. Likewise, it loses its value as the price of the stock goes up.

How Do Stock Options Work?

Employees must stay through the vesting period to get the right to purchase the stock at the discounted rate. Typically, you are granted shares over a period of time. For example, if you’re getting stock options with a five-year vesting schedule, you may be granted some shares at the end of each year and must maintain your employment all five years to get access to all of the stock options.

Buying and Selling Stock Options

You can’t purchase, or exercise, your stock options until they’re vested. There are occasions where employees can speed up the vesting schedule, but these situations are rare. It’s also important to note that there are often time limits for exercising. In many cases, the option to buy at the strike price expires after a certain number of years.

Once you’re vested, you have several choices for exercising your options:

  • Cash payment: In this situation, you can make a cash payment to buy the options.
  • Cashless exercise: You may have the choice to acquire your options at no cost to yourself. In this case, the employer can sell just enough of its stock to cover the cost of acquiring the stock.
  • Sell the shares at the market price: Another option is to purchase the shares and then sell them at the current market price. However, you need to consider the tax implications of selling before doing so.

Like any other form of employee compensation, it’s important to understand what your stock options are worth, how long the vesting period is, and what the tax implications can be. Understanding these key factors can help you make the most of this employee benefit.