What Are Employee Stock Options and How Do They Work?

Job ads in the classifieds mention stock options more and more frequently. Companies are offering this benefit not just to top-paid executives but also to rank-and-file employees. What are stock options? Why are companies offering them? Are employees guaranteed a profit just because they have stock options? The answers to these questions will give you a much better idea about this increasingly popular movement.

A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” You take actual ownership of granted options over a fixed period of time called the “vesting period.” When options vest, it means you’ve “earned” them, though you still need to …

Stock Options Explained

Stock options benefits

Employees who own company stock can directly benefit from the success of their employer, encouraging them to work hard and invest in the outcomes of their duties. Stock options also attract skilled employees when a company doesnt have the resources to offer other competitive benefits and salaries.

Stock options do not have a straightforward value like a salary or signing bonus, but they can still be a valuable asset to someone starting their career. Offering stock options also help businesses retain employees because they rely on long-term growth to gain value from their stocks.

What are stock options?

Stock options are a financial investment where an employee can purchase shares in a company at a preset time and price. Instead of giving away shares directly, employers give their employees the option to acquire a certain number of shares at a discounted rate.

In order for stock options to have value for the employee, the companys shares need to increase beyond the purchase point it offers its employees. Stock options are a flexible investment that allows interested employees to make a profit or own part of the company where they work without making a substantial financial commitment.

How do stock options work?

Stock options have value based on the price of shares compared to the strike price, or the price that an employer allows employees to buy stock options. The strike price is usually the stocks market price when the employer offers the options, but can also be discounted further to provide extra benefits to employees.

While regular stocks can be traded on an exchange, employers set aside shares specifically for employees to purchase, creating a limit on how much of the companys shares they can own.

Once an employer decides to offer stock options to employees, they write out the terms of the options in an employment contract or other legal document. The employer will specify:

An important concept to learn about when reviewing stock options is a vesting period, which is the amount of time it takes for an employee to fully own their shares. Vesting periods allow employers to rely on employees staying with their company for a certain period of time before they use their benefits. They eliminate the chance of new hires immediately selling off their stock and leaving the company.

A common vesting period is four years with a one-year cliff, meaning that after one full year of employment, employees have access to a quarter of their stock options. After that first year, they will be able to gradually earn more of their stock options through monthly or yearly increments until they have received the full amount of shares after four years of employment.

Tips for negotiating a contract with stock options

If a company offers you a job that includes stock options, here are a few tips for ensuring you receive a favorable contract:

Once your stock options are vested, you have a few different options for exercising them. First, you can convert all of your options into stocks, purchase them at the strike price, then sell all of your shares for a profit after a specified waiting period.

For example: If you buy 100 shares of a company at a strike price of $10, you could sell your shares for a profit any time the price of the stock rises above $10.

You can also consider selling some of your stocks after the waiting period and saving some to sell later. This investment strategy can help you make a small initial profit while still keeping some shares for a longer-term investment in your company.

When to exercise stock options

Stock options only have value when the price of the stock is greater than when you purchased the options. If the value of a companys stocks is lower than the strike price they offered, it would make more financial sense to purchase shares on the stock market instead of paying a higher price for employee stock options. If the stocks market price is higher than the strike price, however, you can turn your stock options into profit.

After your vesting period, you can exercise your stock options immediately or wait for the value to rise as a long-term investment. If you are interested in immediately trading your stocks to make a profit, you may benefit from waiting for the stock to rise in value before exercising your options.

Based on the price patterns you see in the stock market, exercise your stocks at a point when their value is higher than the moving average to increase your profitability.

Regardless of when you exercise your stock options, be mindful of when they expire so that you dont miss out on any benefits. Most stock options expire 10 years after the offering date, but there may be some exceptions.

For example: An employer could offer stock options throughout an employees career with the company.


How do stock options work example?

Call example

The current price of the stock is $30. If the price of the stock shoots up to $55 on the day of expiration, Jon can exercise his option to buy 100 shares of CSX at $45 and then sell them at $55 on the day of expiration, making a profit of $10 per share.

How do you make money with stock options?

A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.

Are stock options a good idea?

Options can be a better choice when you want to limit risk to a certain amount. Options can allow you to earn a stock-like return while investing less money, so they can be a way to limit your risk within certain bounds. Options can be a useful strategy when you’re an advanced investor.

Is options better than shares?

Options can be less risky for investors because they require less financial commitment than equities, and they can also be less risky due to their relative imperviousness to the potentially catastrophic effects of gap openings. Options are the most dependable form of hedge, and this also makes them safer than stocks.

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