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What are stock options? Understanding how they work

If your compensation package includes stock options, it's time to discover what they are. Find out here about how stock options work (and what happens if you leave your job).
5 min read
  • Stock options allow employees to buy company shares in the future at a pre-set price. If the market price rises over time, the employee could end up making a profit.
  • They come with a vesting period, meaning that employees have to wait before they can exercise their option to buy the stock.
  • There are different types of stock options, including incentive stock options (ISOs), non-qualified stock options (NSOs), and restricted stock units (RSUs). Each type comes with different rules and tax implications.
Have you ever heard the term "stock options" thrown around in conversations about investing or corporate perks and felt a bit lost? You're not alone.Learning about stock options can seem like a complex maze of financial jargon — but fear not! In this article, we'll break it all down for you.Here, we'll explore what stock options are, how they function, why companies offer them, and how you can potentially benefit from them. Whether you're a beginner investor or an employee trying to decipher your company's benefits package, understanding stock options is key to making informed financial decisions that work for you.

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What are stock options?

If you're working in a cool startup or a big corporation, you might have heard the term "stock options" as part of your job perks. But what exactly are stock options? Imagine you're at a food buffet. Instead of choosing from the available dishes, you can purchase the right to choose certain dishes later — but at today's prices. That's essentially how stock options work, but we're talking about shares of a company's stock.Basically, stock options allow you to buy a set number of company shares at a fixed price in the future. They're not actual shares themselves, but more like a golden ticket to buy shares later at the "strike price" or "exercise price."Of course, you're never forced to actually buy those shares, hence the term "options." Companies add stock options as part of their compensation package, hoping you'll stick around and share in their success. 

How do stock options work?

So, those are the basics. But what's the benefit of jumping in? And how do stock options work? When your company grants stock options, you have the right to buy a certain number of shares at a fixed price. These options typically come with a set timeframe, known as the "vesting period." You need to wait until the end of this period before you can purchase the stock at the fixed price.Once your options vest — meaning you've waited out that timeframe — you can choose to buy the shares at the predetermined price. If the current market price of the company's stock is higher than your strike price, you're in luck! You can buy shares at a discount and potentially make a profit by selling them at the market price. The hope is that you can sell your purchased shares for more than you paid for them.However, if the market price is lower than your strike price, you're not obligated to buy any shares. You can just let the stock options expire, without losing any money.

What are the types of stock options?

Stock options come in different flavors, each with their own rules and potential outcomes. Let's break them down:
  • Incentive Stock Options (ISOs): These are typically offered to employees as part of their compensation package, especially in startups and established companies. Some restrictions apply to who can receive ISOs, and the total value of ISOs exercisable in any calendar year is capped.
  • Non-Qualified Stock Options (NSOs or NQSOs): Unlike ISOs, these can be offered to employees, directors, contractors, and others involved with the company. NSOs don't have the same tax advantages as ISOs, but there's no waiting period, so you can exercise them whenever you want.
  • Restricted Stock Units (RSUs): RSUs are another form of equity compensation. The company promises to give you actual shares of stock at a later date once certain conditions (usually time-based vesting or performance goals) are met. RSUs are granted to you outright and often come with fewer risks. However, they also typically come with fewer potential tax benefits.
  • Employee Stock Purchase Plans (ESPPs): While not exactly stock options, ESPPs are worth mentioning. These plans allow employees to purchase company stock at a discount, usually through payroll deductions. The discount can be a substantial benefit, and ESPPs often come with tax advantages if you hold onto the shares for a certain period.
Those are the main types of stock options you're likely to encounter. Each type has its pros and cons, so it's essential to understand the specifics of your stock option plan and how they fit into your overall financial goals.

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What happens to stock options if you leave your job?

What happens to your stock options when you leave your job depends on the type of options you have and the specific terms outlined in your employment agreement or stock option plan. Here's a general overview of what might happen:
  • If your stock options have already vested (meaning you've met the requirements to exercise them, such as staying with the company for a certain period), you typically have a window of time to exercise them after leaving your job. This window can vary but is often between 30 to 90 days after employment ends.
  • If you leave your job before your stock options have fully vested, you typically forfeit any unvested options. However, some companies may have provisions for partial vesting or accelerated vesting in certain circumstances, such as termination without cause or a change in control of the company.
  • In some cases, such as retirement, disability, or death, companies may have special provisions for treating stock options.
  • If your company is acquired or merges with another company, the treatment of your stock options may be governed by the terms of the acquisition agreement.
In short, what happens to your stock options when you leave your job can vary depending on the type of options you have, your employment agreement, and the specific circumstances of your departure. Reviewing the terms of your stock option agreement is essential — and you might want to consult with a financial advisor or tax professional for more personalized guidance.

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Disclaimer

These statements do not constitute investment advice relating to any financial instrument. Financial instruments can be subject to high fluctuations in value. A decline in value or a complete loss of the money invested is possible at any time.

FAQ

    The strike price, also called the “exercise price,” is the pre-set price that an option holder can buy or sell the stock at. The market price is the current trading price of the stock.

    The taxation of stock options varies depending on the type of option and when you exercise it. It's important to consult with a tax professional to understand the tax implications in your specific situation.

    An option chain is a listing of all available option contracts for a given security, like a stock. It typically includes information like strike prices, expiration dates, and current bid/ask prices. This can help investors make more informed decisions about which options to trade.

    Companies often consider factors like the employee's position, performance, and potential value to the company when determining stock option grants. The company's equity compensation plan may also limit the total number of options that are available.

    Time decay, also known as theta, refers to how much value an option loses as it approaches its expiration date. This concept is important for option holders to understand, as it can significantly impact how profitable their options are likely to be.

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