Stock Option for Dummy: How do Stock Option Trading work?

Stock options are perks employees gain from their employers. Basically, stock options give an employee a right to purchase a set amount of shares of company stock during a specific time period at a set price. The strike price (the option price of company stock) is discounted and can be the price of the stock at the time the employee gained options rights or, in the case of privately held firms, it is the internal valuation of the stock at the historical time period that is then voted on by the board of directors.

For example, an employee is hired on at a publicly traded firm and has this perk; the strike price will be the price of the stock on the day the employee was hired. This same company may allow the employee to exercise the option 1 year later in the volume of 100 shares. So, this employee will be allowed to buy 100 shares of the stock, 1 year in the future, at the price it was a year before when the employee was hired. The hope is that the stock price goes up during the period and the employee gains real benefit from exercising the options. Usually the amount of shares the employee can buy is vested over a period of time. If it were 4 years, the employee would purchase 25% the first year at the strike price, another 25% the second year at the strike price, etc.

The tax implications depend upon whether the options can be classified as incentive stock options (ISOs) or non-qualified stock options (NSOs). NSOs are more common than ISOs and carry more of an immediate tax burden than do ISOs. NSOs are far simpler for a company to structure for their employees, but don’t meet all the qualifications for an ISO that are established by the IRS. In the case of an ISO, ordinary income tax is paid when the option is exercised meaning the difference between the strike price and the market price is treated as ordinary income. For ISOs, the tax implications do not come into play until the stock is sold. Simply exercising the options by turning them into stock shares does not carry any tax burden. Capital gains taxes on ISO stock options are only figured when the stock is sold. NSO stock options are effectively taxed twice if the shares are held onto after the options are exercised and when sold capital gains taxes must be paid. Obviously, there is a big difference in the amount of taxes paid between ISO and NSO options and its very important to understand which type an employer is offering.

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