Trading Stock Options
Stock options have become the new currency of employee compensation and not just among the ranks of top executives. In more and more companies, all employees are getting stock options, contracts that allow them to buy stock at a fixed price, even if the market value of the stock rises. Along with asking for a nice salary, health benefits, many job candidates are now demanding stock options. And there is even a trend within the trend: during the early years of the Internet boom, employees would accept a low salary in exchange for stock options; now they are starting to get high salaries as well as stock options as a way to attract and retain qualified employees. Employers line using stock options because they encourage people to work for the good of the company; the employee, in a sense, becomes an owner and partner.
WHAT ARE STOCKS?
Before we can define stock options, we must define what a stock is. A share of stock represents partial ownership in a company, based on a finite number of shares that the company has issued.
A share of stock has a current market price, determined by a bid auction system on a stock exchange. To get listed on a stock exchange, a company must meet certain minimum standards for the size of its assets, the amount of its sales and so on. If a company does get listed, the exchange will monitor it. If the company falls below the minimum standards, then the exchange has the right to remove it. Such companies will, in most cases, be transferred to another exchange with lower minimum standards. Delisting may also occur when one company purchases another.
New York Stock Exchange (NYSE), founded in 1792, this is the oldest stock exchange in the United States. The exchange has a physical trading floor, on which professional traders buy and sell stock. The NYSE has the most rigorous listing standards of any stock exchange in the United States.
American Stock Exchange (AMEX). This market too has a physical trading floor and is based in New York, although the AMEX caters primarily to medium size companies. The AMEX merged with Nasdaq in 1999.
National Association of Securities Dealers Automated Quotation System. This market does not have an actual trading floor; it is purely an electronic exchange. Created in 1971, Nasdaq has grown quickly, routinely trading more than one billion shares on any given day. For the most part, smaller companies list on Nasdaq.
Regional exchanges. These are U. S. based exchanges that cater to specific regions of the country. These markets focus primarily on small companies in their regions.
Bulletin Board Exchange. This too is an electronic exchange. The companies are fairly small and the trading volume low. Many so called penny stocks trade on this exchange.
Foreign Exchanges. Most developed countries have their own stock exchanges. Some of the larger foreign companies list their stocks not only on the exchange in their home market but also on a U. S. exchange, such as Nasdaq or NYSE.
A foreign company that is listed on a U. S. stock exchange is traded through an investment called an American Depository Receipt (ADR). Here is how it works: A foreign company will deposit some of its shares in a bank. A bank will then issue ADR shares against the deposit. The bank will handle the many administrative concerns, such as dividend payments, taxes and currency conversion.
If a stock is not listed on an exchange, then it is a private company. In that case, it is very difficult to sell your shares or even to know what they are worth. If you can find a buyer, the price you will be offered typically will represent a steep discount from what you would get if you had access to lots of buyers.
WHAT ARE STOCK OPTIONS?
A stock option is a contract between you and a company. The option gives you the right to buy a fixed number of shares in the company for a fixed price, called the exercise price. You have a limited time to purchase the shares, typically up to ten years. When a company grants you stock options, it must provide you with the following information:
Option contract. This contract sets out the terms between you and the company, such as :
Number of shares
Vesting
Exercise price
Type of option
Termination
Option plan. This sets forth the general policies regarding a company's stock option plan. It will cover such things as:
Eligibility for the options
Vesting
Changes in capital structure
A company may provide employees with other helpful information, such as answers to frequently asked questions, which anticipate the most common things employees want to know about their stock options; videos; seminars and one-on-one meetings with benefits counselors or personnel from the company's human resources department. Increasingly, companies are posting stock option information on their corporate "intranets". But some companies do not yet provide good sources of extra information.
When you are granted stock options, make sure you ask the person who administers the plan as many questions as you can. But keep in mind that this person is not allowed to provide personalized advice on matters such as your tax situation and when you should exercise your stock options.
And do not pay attention to what other employees are saying about the stock option plan. The grapevine spreads many plausible sounding rumors and buying into such scuttlebutt can lead to bad decisions about your stock options.
INCENTIVE STOCK OPTIONS
Incentive stock options (ISO) are not as common as nonqualified stock options. ISOa have special tax features that can be particularly beneficial for the employee.
When you are granted an ISO, you do not owe any taxes. Even if the options vest and you do not exercise them, there is still no tax. This may seem self evident, but as we shall see with nonqualified stock options, it is possible to owe income intaxes when the options are granted.
Generally, you will owe taxes on ISOs when you either exercise the options or sell the stock after exercising the options. Depending on the circumstances, the taxes may be based on the alternative minimum tax (AMT), ordinary income or capital gains. Before looking at these tax structures, let us first understand how a stock option grant is classified as an ISO.
Criteria for ISOs
How do you know if the option you have is an ISO or a nonqualified stock option ? Of course, your company will tell you and it will also be stated in your option agreement, but here are the rules, for your reference:
Option plan. An ISO must be granted in accordance with a company option plan, which sets forth the basic terms of the company?s option policies. Further more, ISOs cannot be granted more than ten years after the plan has been established. Interestingly enough, the principal requirements for a stock plan are minimal. The only specifies that must be in writing are the total shares to be granted and the types of employees eligible for the options. The company's board of directors must approve the option plan and shareholders must approve it within twelve months of the director's approval.
Length. An employee may not exercise an ISO later than ten years after the option grant. If an option holder owns more than 10 percent of the company?s voting stock, then the time frame is five years.
Exercise price. The exercise price cannot be lower than the current fair market value owns more then 10 percent of the voting stock, then the minimum exercise is 110 percent of the current fair market value.
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