About Exercised Stock Options

Stock options have become a common method of increasing leverage or hedging risk. Rather than buying or selling an actual stock, stock options are contracts that give the holder of the contract the choice, or option, to buy or sell the stock at a certain price and in a certain date range, both specified in the contract. The action of choosing the option granted by the stock option contract--actually buying stock from or selling stock to the writer of the contract--is known as "exercising the option."

Employee Stock Options

Employers offer stock options as another form of incentive to employees, particularly at upper management levels where increasing the value of the company is the employee's ultimate task. Employers may give their employees the option to buy company stock at a certain price by a certain date; it is then in the interest of the employee to do whatever is possible to raise the stock price, and it is also the decision of the employee when and whether to exercise the option to purchase stock.

Exercising Employee Stock Options

When employee stock options are exercised, the employee must still come up with the cash to purchase the stock. Often the employee may not have the cash required and must borrow the money from their broker, who then charges a daily interest rate until the stock is sold. However, if the stock is purchased with money borrowed from a broker but sold the same day, no interest is charged. Thus, the employee may want to immediately sell the stock at the current market price in order to avoid paying interest, and keep the difference between the strike price (or the price at which the option allows the employee the purchase stock) and the current market price. Of course, if the current market price is below the strike price, the employee would not want to exercise the option.

Holding Stock vs. Immediately Selling

On the other hand, if the employee does immediately sell stock purchased from exercising stock options, any benefits of owning stock are forfeited. These include appreciation of stock price and any dividends that may be paid. Any appreciation of stock price above the market value of the stock at the time at which the stock was purchased (not the strike price) will also be subject to capital gains tax. These factors must be taken into consideration.
The employee can also exercise her stock options and then only sell enough stock to cover the cost of purchase; for example, the employee may exercise options to purchase 100 shares at a strike price of $1, meaning the employee paid $100 to purchase the stock. If the current market value of the stock is $10 per share, the employee could immediately sell 10 of those shares to cover the cost of purchasing the stock (or slightly more shares to also cover income tax). The remaining shares could be held in an attempt to collect dividends and allow the stock to appreciate in value.

Exchange Traded Stock Options

Individuals write option contracts for any stock and sell them in the open market, and other individuals can buy these option contracts. These are known as exchange traded stock options. These contracts take on a certain value depending on the stock price and the amount of time left before the contract expires. For example, if a stock is currently trading at $5 per share, a contract granting the option to purchase the stock at $10--more than the stock is currently worth--would be worth less than a contract to purchase the same stock at $1, since the stock purchased at $1 could be immediately sold at $5 for a profit, while the stock purchased at $10, if immediately sold, would be sold at a loss. Additionally, a contract that expires in one year is worth more than a contract that expires tomorrow, since there is a much higher probability of the stock price moving in a favorable direction sometime within the next year than sometime before tomorrow. Thus, the value of an option contract, if the stock price stays the same, will decrease over time.

Calls vs. Puts

The option contract described above is known as a "call," which gives the buyer of the contract the right to purchase stock from the writer of the contract at a certain price by or on a certain date.
Similarly, contracts can also be written that give the option to sell stock at a certain price by a certain date to the writer of the contract. This type of contract is known as a "put," and the value of the contract moves oppositely to the value of the corresponding call contract. A call contract granting the right to purchase stock at $10 when it trades at $5 is worth far less than a put contract granting the right to sell stock at $10 when it currently trades at $5. The call contract, if exercised, loses $5 per share, while the corresponding put contract for the same stock at the same strike price gains $5 a share when exercised.

Exercising Exchange Traded Stock Options

To exercise an exchange traded stock option means to buy or sell stock at the strike price to or from option contract writer, who must fulfill the obligation of the contract. The contract holder has the choice of whether or not to exercise that option.
The question of when a contract holder can exercise an option depends on the type of option contract. American-style options allow exercising of the option anytime until expiration. All stock options traded in the United States are American-style. Some index options are European-style, meaning that the options can only be exercised on the expiration date of the contract. Until then, the contract may only be traded.
When an option expires, unless the individual specifies otherwise, many brokers automatically exercise "in-the-money" options, which are the options whose exercise would be profitable; for call contracts, the current market value would be above the strike price, and for put contracts, the current market value would be below the strike price.

Considerations for Exercise

Considerations for exercising exchange-traded stock options are similar to those for employee stock options. The option is in-the-money, the option can be exercised and the stock immediately bought or sold to capture the difference between the strike and current market price. What is different about exchange traded stock options from employee stock options is that the option contract can always be traded until expiration. Until the expiration date, it is generally more profitable to trade an option contract than to exercise, because on top of the profit that would be captured if the option is exercised, there is additional value in the contract based on the amount of time remaining before expiration. An option contract that expires in one month may profit $10 per share based on the difference between strike and current market price of the stock if exercised now; however the contract itself can be sold for more than $10 per share.
Dividends also factor into exercising call options - specifically, the option must be exercised prior to the ex-dividend date in order to capture the stock's dividend.