Trading Education: Employee Stock Options

September 2, 2011 / Greg Jensen

There are two forms of stock options: one form is the employee option and the other is the equity option. Companies issue employee options granting their workers the opportunity to buy shares of the company and therefore own part of it. Naturally, the value of the stock will rise the more successful a company is. The concept works as a motivational tool. In theory, if an employee owns the share, they will work their hardest to ensure the value rises so they may one day cash out ahead. The price of this stock is set by company directors and it is usually higher than its current value. Another method that is sometimes used to value the stock and determine the price of the stock to the employee is a six month expiration period. What this means is that an employee expresses interest in the stock but does not yet receive it. The company then monitors that stock over the course of the next six months and sells it to the employee for the average price over that period of time.

There are two main types of employee stock options. The first is Non-Qualified Stock Options. With NSOs, a holder is required to pay tax on the profit earned from the stock. Many employers like NSOs because they can use them as tax write-offs. The other type of employee stock options is Incentive Stock Options. ISOs must be held for at least two years after they were granted and at least one year after they were exercised. They are taxed as capital gains, not based on their income. Also, employers cannot use them as tax write-offs.

The worth of a stock based on two values: the intrinsic and extrinsic. By subtracting the strike price (how much was paid for the stock) from the amount the stock is currently trading for, the intrinsic value can be determined. If the math leads a number below zero, then the intrinsic value is merely nothing. It can never be negative. The extrinsic value, on the other hand, isn’t as easy to determine. It is a time factor – how much will the stock be worth in a year, in two years, or in the distant future? In order to estimate this amount, one needs to consider the stock’s prior trends and volatility. The more volatile a stock is, the more it fluctuates in value and therefore, the more potential it has to have a significantly higher worth in the future.

Once a company’s stock price is higher than its strike price, an employee will want to take advantage of it. They may choose to buy the stock for cash if they haven’t already done so, and then resell it for profit. Sometimes, the employee will not have the cash available. In this case, they might be able to work out a cashless solution with their employer. In doing so, the employer will sell one of their shares, keep the strike value and turn the profit proceeds over to the employee’s account.

There are also equity options which are different from stock options. It is important never to confuse the two. One difference is that equity options can be traded. Another is that they carry a multiplier while stock options always amount to one single share. Equity options also require margins, or collateral, that covers their credit risk during a short expiry period. Stock options always have long expiry periods and therefore have no credit risk and do not require margins. Finally, stock options are granted to an employee. It is evident by the cashless solution outlined above. Equity options are strictly sold.

Stock Options

Learn stock options via the Internal Revenue Service

Employee Stock Options Plans

The U.S. Securities and Exchange Commission outlines what the options are

“How Stock Options Work” (PDF)

This article from Stanford outlines employee stock options, briefly but in detail

“Should I Exercise My Stock Options?”

An experimental calculator designed by Steven Huddart of Penn State

Kiplinger (PDF)

“Five Keys to Investing Success,” an article from Kiplinger’s Personal Finance Magazine

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