Stock options are a type of financial instrument that give the holder the right, but not the obligation, to buy or sell shares of a company’s stock at a predetermined price, known as the strike price. Stock options can be an attractive form of compensation for employees, as they provide the potential for significant gains if the underlying stock price increases.
There are two main types of stock options: call options and put options. Call options give the holder the right to buy shares of stock at the strike price, while put options give the holder the right to sell shares of stock at the strike price.
When an employee is granted stock options, they typically have a vesting period, during which they must wait before exercising the options. Once the options have vested, the employee can choose to exercise the options by purchasing shares of stock at the strike price. If the stock price has increased above the strike price, the employee can sell the shares for a profit.
For example, let’s say an employee is granted 1,000 call options with a strike price of $50 per share, and the stock price at the time of grant is $50 per share. The options have a vesting period of four years, with 25% vesting each year. After one year, 250 options have vested, and the stock price has increased to $60 per share. The employee can exercise their vested options by purchasing 250 shares at $50 per share, and then sell them for $60 per share, netting a profit of $2,500.
It’s important to note that stock options have a expiration date, after which they become worthless. This means that if the stock price doesn’t increase above the strike price before the expiration date, the employee may not realize any gains from their options.
Another factor to consider is the tax implications of stock options. When an employee exercises their options, they will typically owe taxes on the difference between the strike price and the current market price of the stock. If they hold the stock for more than a year before selling it, they will be taxed at the long-term capital gains rate, which is generally lower than the short-term capital gains rate.
Overall, stock options can be a valuable form of compensation for employees, providing the potential for significant gains if the underlying stock price increases. However, it’s important to carefully consider the vesting schedule, expiration date, and tax implications before exercising options.