'Exercise Stock Option' Definition

Exercising stock options creates a taxable event.

Understanding when to exercise stock options is an important financial consideration for company employees given this type of compensation. Exercising options is electing to buy stock in the company by a specified date and at a stated exercise price.

Basics

Once considered only for executives, more than 9 million regular employees in the U.S. have stock options in 2010, according to CNN Money. A stock option "gives you the right to buy ("exercise") a certain number of shares of your employer's stock at a stated price (the "award," "strike," or "exercise" price) over a certain period of time (the "exercise" period)," according to CNN Money.

Types

Nonqualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are the two common formats for stock options. NSOs create an option to buy a certain number of stock shares at a fixed price, usually related to fair market value at issuance, and an expiration date of 10 years or less. ISOs are similar but must have an exercise (buy) price below the fair market value of the stock at the time of issuance.

Tax Considerations

When you exercise stock options, you create a tax event. The effect varies considerably by type. With NSOs, gains on the difference between market value and exercise price are ordinary income for taxes. Any gains realized after the option date is capital gain with lower taxes. With ISO, if you hold options for two years from granting and one year from exercise, generally all gains are considered capital gains.

References

• CNN Money: Money 101 Lesson 10: Stock Options
• Smart Money: Options: Should I Exercise?
• GROCO: When to Exercise Your Stock Options