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How Do Stock Options Work? A Comprehensive Breakdown

How do stock options work? A comprehensive breakdown

Similar to stocks, stock options can work in or out of your favor. Stock options are a vehicle that gives someone the right to buy or sell shares of a particular stock at a specified price, for a finite period. Stock options are traded on exchanges, much like stocks. Each stock option bears an original price. Moving forward, the price of stock options can go up or down.

There are many terms and rules for stock options. It’s important to know the terms for exercising stock options, so you understand the process of how they make money and how they lose money. It’s also important to know the rules to prevent problems with the IRS.

And before we get into the details, remember you can get started for free with Diligent Equity which makes option administration easy!

Understanding Stock-Related Terms

The financial services industry has developed a host of terms that are confusing to non-financial people. We’ll help to define them for you.

  • Employee stock option: Companies sometimes offer their employees stock options as an incentive. Employees can purchase a set number of shares at a certain price for a specified period.
  • Call option: Gives the stock option owner the right to buy stock at a specified price during a set timeframe.
  • Put option: Allows the buyer the option to sell shares of the stock at a set price within a set period of time.
  • Strike price: Price that’s set when you can exercise your options.
  • Premium: Premium is the amount the buyer pays for the option. It reflects the maximum profit the seller can make which is similar in selling common stock.
  • Bid price: A buyer of stock options will decide what price they’re willing to pay, and this is called the bid price. Sellers of stock options decide what price they’re willing to sell their stock options and that is the ask price. Bear in mind that a stock option contract covers 100 shares of underlying stock, so you have to multiply the bid and stock prices by 100 to arrive at the price for the option contract.
  • Vesting date: Shares typically vest gradually over time. The vesting date is the date that you can do something with your grant. You can only exercise the vested shares. The contract may also state that you can vest your shares all at one time, which may be after an initial period of a few years. This is known as cliff vesting.
  • Expiration date: The contract for most stock options in the U.S. follows a standard options calendar. The expiration date is usually on the third Friday of the month that they’re set to expire. Stock option holders have the option of buying or selling shares according to their contract, selling the entire option, or just let it expire. Stock options are worthless once they expire.
  • Cashless exercise: This isn’t always available, but if it is, stock option holders can exercise their options and sell them almost immediately. The proceeds of the sale usually go into the holder’s brokerage account so they can reinvest them somewhere else. The holder can also have the estimated taxes held at that time. If the market price of the stock is lower than the strike price, it’s best to just let the options expire.
  • Cashless hold: In this case, the stockholder exercises their options and sells enough shares to cover the costs. They hold the remaining shares for investment purposes.

How Do Stock Options Work?

Stock options are part of the underlying stock. As such, their price is tied to the movement of the underlying stock. If the stock price goes up or down, the stock options follow suit.

One of the differences between stocks and stock options is that contracts for stock options cover 100 shares of the underlying stock. The buyer’s price and the seller’s price both affect the premium for the option. The intrinsic value is the difference between the option’s strike price and the underlying stock’s market price. The premium is also affected by the time that the option expires and any changes in the underlying stock prices during the time the option is held.

There are two other common terms that you’ll hear when talking about stock options and they’re “in the money” and “out of the money.” Where the strike price is above the market price, the stock is referred to as being “in the money.” Where the strike price is above the price of the stock, the stock is referred to as “out of the money.”

It’s crucial to understand these terms because they will be listed in the option agreement. Don’t skim over the option agreement—read it. If there’s something you don’t understand, it’s best to consult with a tax or financial professional. Owning stock options gives you rights and responsibilities regarding compensation and investing. Stock option owners need to be aware of how to exercise their options so that they make money and don’t risk losing it and that they don’t suffer any negative consequences of taxes.

Stock options are designed to be part of an overall financial plan. A financial advisor is the best resource to guide someone on how to fit their stock options into their overall investment strategy and financial plan.

As a word of caution, buying too many stock options in the same company could over-allocate the stock option owner to one company’s stock. If the company suffers a financial decline and their stock prices drop, an owner could lose a large sum of their net worth. This is why many financial advisors use the phrase, “Don’t put all your eggs in one basket.”

Finally, the best thing that a financial advisor can do for stock option owners is to help them commit to an investing strategy. Be aware that public companies set specified windows where their employees can buy and sell stock. A financial advisor helps set up a personal financial strategy for buying, holding and selling stock as part of an overall financial plan. Also, a financial advisor guides their clients on how to account for tax planning in relation to investments.

Cap tables are highly complex, and they can be challenging to keep updated. Diligent Equity takes the hassle out of managing your cap table. The software keeps track of all your terminations, transactions, financing rounds, certifications, and employee options updated accurately. To make things even easier, the software will also send reports directly to your auditors. Diligent Equity takes the hassle out of maintaining your cap tables.

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