Understanding the Benefits and Risks of Stock Options
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Summary:
Stock options are contracts that give the holder the right to buy or sell a specific amount of stock at a set price, known as the strike price, on or before a specific date. There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). While stock options can be attractive, there are also risks associated with them, including volatility, concentration risk, limited upside potential, expiration risk, and tax implications.
If you’ve worked for your company for a long time, you may have received a set of company stock options. But what are stock options, and how do they differ from other stocks you can invest in?
Today, we’ll take a closer look at stock options, how they work, and what types of stock options are available. We’ll also explore the potential risks and benefits of accepting stock options as part of your compensation package.
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How stock options work
Stock options provide a person (typically an employee) the right to purchase company stock at a set price, known as the “strike price.” The employee then has a specific period (before the options expire) to decide whether they want to exercise the options or purchase the stock at the strike price.
With this in mind, remember that you don’t have to exercise your stock options if you don’t want to. You can choose to hold onto the options and potentially exercise them at a later time if you believe the stock price will continue to rise. However, if the stock price does not rise above the strike price by the time the options expire, they will become worthless.
Example of how stock options work in practice
Imagine you work for a company called XYZ. As part of your compensation package, you’re granted stock options for 1,000 shares of company stock at a strike price of $50 per share. The options expire in five years.
Two years later, XYZ’s stock price rises to $75 per share. You decide to exercise your options, paying the strike price of $50 per share to purchase the stock for a total cost of $50,000. You then immediately sell the shares on the open market for $75 per share, generating proceeds of $75,000. After deducting the original cost of $50,000, you have made a profit of $25,000.
It’s worth noting that if the stock price fell below the strike price of $50 per share, you would not have realized any profit. However, the options would have become worthless if you didn’t exercise them before they expired. This highlights the importance of understanding the potential risks of stock options before accepting them as part of your compensation package.
Types of stock options
There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Here’s a breakdown of each type:
1. Incentive stock options (ISOs)
Incentive stock options (ISOs) are typically granted to executives and key employees as part of their compensation packages. These options offer tax advantages to employees who hold the options for at least two years from the grant date and one year from the exercise date.
If the holding period requirements are met, any profit made from the sale of the stock is taxed as a long-term capital gain. This is typically taxed at a lower rate than ordinary income.
2. Non-qualified stock options (NSOs)
Non-qualified stock options (NSOs) are granted to all employees, including executives and non-executives, and do not offer the same tax advantages as ISOs.
With NSOs, the difference between the fair market value of the stock at the time of exercise and the strike price is taxed as ordinary income at the time of exercise. This can result in a significant tax bill for employees who exercise their options when the stock price is high.
Pros and cons of stock options
While stock options can be a valuable form of compensation, they come with certain risks that you should be aware of.
Pros explained
- Incentivizing employees. Companies use stock options as a way to attract and retain talented employees. Stock options can provide a powerful incentive for employees to work hard and help grow the company’s value, as the value of their options will increase as the company’s stock price goes up.
- Potential for financial gain. Stock options can offer significant financial gains for the holder if the stock price increases over time. This can result in substantial profits, especially if the holder has a large number of options.
- Flexibility. Stock options offer flexibility in terms of when and how they can be exercised. The holder can choose to exercise the options at any time before they expire, allowing them to take advantage of favorable market conditions.
- Limited risk. Unlike buying stock outright, the holder of stock options has limited risk. If the stock price decreases, the holder can simply choose not to exercise their options, limiting their losses to the cost of the options themselves.
Cons explained
- Stock price volatility. One of the main risks of stock options is that the stock price can be highly volatile, meaning that it can fluctuate significantly over short periods of time. If the stock price falls below the strike price of your options, they will become worthless.
- Concentration risk. If you hold a large portion of your net worth in your company’s stock, you are subject to concentration risk. This means that if the company runs into financial trouble, your entire net worth could be at risk. To avoid this, make sure you diversify your investments.
- Expiration risk. Stock options have an expiration date, meaning that if you don’t exercise them before they expire, they’ll become worthless. It’s important to keep track of the expiration dates of your options and exercise them promptly if you choose to do so.
- Tax implications. As we discussed earlier, there can be significant tax implications associated with stock options. If you exercise NSOs when the stock price is high, you may be subject to a significant tax bill. To understand the tax implications of your options, consult with a tax professional.
FAQs
Are options better than stocks?
It depends on your investment goals and risk tolerance. Options offer the potential for higher returns than stocks, as they allow you to control a larger amount of stock with a smaller investment. However, options also come with higher risks, as they can expire worthless. Because of this, options can require a higher level of knowledge and expertise to trade effectively.
Stocks, on the other hand, offer more stability and a long-term investment opportunity, but with lower potential returns. That said, individual stocks still experience more volatility than, say, exchange-traded funds.
What is the difference between stock and stock options?
Stock represents ownership in a company, while stock options give the holder the right to buy or sell stock at a set price on or before a specific date. Owning stock gives the investor voting rights and the potential for dividends, while stock options offer the potential for profit through the difference between the strike price and the current stock price. Stock options also come with higher risks and a higher level of complexity compared to owning stock.
Key Takeaways
- Stock options give the holder the right to buy or sell a specific amount of stock at a set price on or before a specific date.
- There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs).
- Careful evaluation and guidance from a financial professional are recommended before accepting stock options as part of a compensation package.
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