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Stock options are a type of alternative compensation that some companies, including many startups, offer as part of their package for employees. Employees come on board at perhaps a lower-than-normal salary in exchange for the possibility of a big payday later on.

Talk to a financial advisor work with an option you have questions about your stock options or any other investments. Stock Options Definition Stock options are a form of compensation.

Companies can grant them to employees, contractors, consultants and investors. These options, which are contracts, give an employee the right to buy or exercise a set number of shares of the company stock at a pre-set price, also known as the grant price. You have a set amount of time to exercise your options before they expire.

Essential Options Trading Guide

Your employer might also require that you exercise your options within a period of time after leaving the company. The number of options that a company will grant its employees varies, depending on the company. It will also depend on the seniority and special skills of the employee. Investors and other stake holders have to sign off before any employee can receive stock options. You and the company will need to sign a contract which outlines the terms of the stock options; this might be included in the employment contract.

How do stock options work?

When a stock option vests, it means that it is actually available for you to exercise — that is, to buy. Unfortunately, you will not receive all of your options right when you join a company; rather, the options vest gradually, over a period of time known as the vesting period. A four-year work with an option period means that it will take four years before you have the right to exercise all 20, options. Stock Options: How to Exercise Once trading a successful trader options vest, you have the ability to exercise them.

This means you can actually buy shares of company stock.

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Until you exercise, your options do not have any real value. The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well or poorly the company does, this price will not change.

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You can also hold it and hope that the stock price will go up more. Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options.

How Do Employee Stock Options Work?

There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction.

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To do this, you will purchase your options and immediately sell them. Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it work with an option you to buy the shares.

Another way to exercise is through the exercise-and-sell-to-cover transaction.

With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest. You can find this in your contract. When You Should Exercise Stock Options When and how you should exercise your stock options will depend on a number of factors.

You would be better off buying on the market. But if the price is on the rise, you may want to wait on exercising your options. Once you exercise them, your money is sunk in those shares. So why not wait until the market price is where you would sell? That said, if all indicators point to a climbing stock price and you can afford to hold your shares for at least a year, you may want to exercise your options now.

The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction i. An option that conveys to the owner the right to buy at a specific price is referred to as a call ; an option that conveys the right of the owner to sell at a specific price is referred to as a put.

Also, if your time period to exercise is about to expire, you may want to exercise your options to lock in your discounted price. Stock Options and Taxes You will usually need to pay taxes when you exercise or sell stock options. What you pay will depend on what kind of options you have and how long you wait between exercising and selling. They do not receive special tax treatment from the federal government.

Incentive stock options ISOswhich are given to executives, do receive special tax treatment. With NQSOs, the federal government taxes them as regular income.

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The company granting you the stock will report your income on your W The amount of income reported will depend on the bargain element also called the compensation element. When you decide to sell your shares, you will have to pay taxes based on how long you held them. This type of capital gain is subject to the regular federal income tax rates. If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year.

Benefits of Stock Options The price the company sets on the stock called the grant or strike price is discounted and is usually the market price of the stock at the time the employee is given the options. Since those options cannot be exercised for some time, the hope is that the price of the shares will go up so that selling them later at a higher market price will yield a profit. You can see, then, that unless the company goes out of business or doesn't perform well, offering stock options is a good way to motivate workers to accept jobs and stay on.

ISOs operate a bit differently. You do not pay taxes when you exercise ISOs, though the amount of the bargain element may trigger the alternative minimum tax AMT.

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When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain element is treated as regular income.

Bottom Line Stock options are becoming a more common way for companies to attract and keep employees.

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Option terms are set by the individual company through a contract you must sign. You should familiarize yourself with the terms in that contract. It will tell you how many options the company is granting and the length of the vesting period. The contract will also have the grant price, which is what you will pay when you exercise those options.

The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option.

How and when you exercise options will depend on the price of the shares. There are also income tax considerations, with the promise of lower tax rates if you hold onto your shares for at least one year. A financial advisor can help you figure this out, all while ensuring a sale is in the best interest of your long-term financial plan.

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Get started now. Exercising and selling will impact your taxes.