Investing, Lifestyle

Stock Options: Understanding the Benefits

Stock options can be an attractive employee benefit. This investment may allow you to realize a large profit based on an increase in the stock’s price. Options can also be hard to understand. Here I will provide some tips to help you make smart decisions when it comes to stock options.

How they work

A stock option is a contract. Option buyers pay for the right to purchase a certain number of shares of stock at a specific price (called the strike price or exercise price) for a period of time. The seller is obligated to sell the stock at the specified price if the owner of the option chooses to exercise their contract. The buyer can also let the option contract expire without using it.

One March IBM 50 call option, for example, allows the buyer to purchase IBM stock at $50 per share. And one option controls 100 shares. The option will expire on a specific date in March. Options are securities that are bought and sold each business day on exchanges, such as CBOE.

Options as an employee benefit

Stock options are sometimes granted to employees as a benefit. The rationale is that if a key employee stays and works productively, the company’s earnings will increase. As earnings increase, so will the stock price. Over time, the market price of the stock will be higher than the stock option price.

To exercise a stock option, the employee must be vested. Vesting means that the worker has earned the right to exercise the stock option. Vesting typically happens based on years of service.

Once an employee is vested, they can exercise the option. This site goes into more detail on the concept of vesting. When that occurs, the employee buys the stock at the strike price and sells the stock at the higher current market price. Many companies simply pay the employee the difference between the strike price and current market price and handle the stock purchase and sale at the company level. This method allows the worker to benefit from the stock price increase, without paying out-of-pocket for the stock purchase.

How to benefit from stock options

If you work for a business that is considered a “public company”, your firm may offer stock options as an employee benefit. A public company’s common stock is traded on an exchange. It’s a stock that any investor can buy or sell. Pepsico, for example, is a publicly traded stock. Employees of Pepsico might be offered stock options.

Assume that you have the choice of receiving stock options as a benefit, instead of a higher salary. Which choice is more attractive? If the company’s sales and earnings grow, the stock price may increase significantly over time. You may be able to exercise your options and sell shares for a large gain- much larger than the salary increase. Stock options may be the better financial choice over the long-term.

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