How to Exercise and Sell Stock Options
There are two types of stock options, those that are traded in the open market (NSOs) and those vested with employees as part of their compensation which qualify for special tax treatment (ISOs). Most employees do not closely follow the stock market or read the fine print on their incentive stock options (ISOs), so some direction in this area can be quite helpful. Among the greatest challenges is avoiding a cash outlay in exercising options, and avoiding taxes to the fullest extent possible.
- Difficulty:
- Moderate
Instructions
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1
Know the date at which your options become eligible for exercise. If the company fails before that time, exercising stock options becomes meaningless.
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2
Try a cashless exercise. An option represents the right to buy shares of a stock at a set price, called either the strike or grant or award price. Even though this price can be significantly lower than the current market price, purchasing all that stock can still be quite expensive. One solution is to initiate a cashless exercise in which the broker holding your options buys the stock for you on credit and then sells enough of it at the market price to cover the purchase. What remains, the difference between the strike and market prices, less transaction costs, is credited to your account.
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3
Consider a stock swap. Another popular method of exercising options is the stock swap in which currently owned shares of the stock are sold to finance the exercise of the options. Usually this exchange is done directly with the company itself. Instead of cash being credited to the account, the result will be an increase in the overall number of shares owned.
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4
Pay cash. Remember, an option is only the right to buy a stock at a predetermined price. So, of course, if you have the means, you can always simply lay out the cash yourself to exercise the options. This is only desirable, of course, if this strike price is below the current market price. In almost all cases, however, one of the two previous strategies is employed to avoid a cash outlay in the exercise of options.
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5
Consider taxes. If options weren't taxed, exercising them would be a simple matter of waiting until the company's stock had risen. On NSOs, regular income taxes are assessed on the difference between the strike price at the exercise price. Any additional increase after the exercise is taxable as a capital gain. ISOs have the benefit of being taxed only on the difference between the exercise price and the final sale price. If the stocks are held after the exercise for at least two years, any difference becomes a long-term capital gain, assessed at a lower tax rate. If the final sale price is below the exercise price, even if significantly above the initial grant price, ISO shares might not be taxed at all.
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Tips & Warnings
A common reason for exercising stock options is to prevent concentration. It's recommended that no more than 10 percent of your total portfolio be held in in employer stock. Exercising options periodically instead of all at once can prevent entering a higher tax bracket.
Stock prices can be volatile and a company's value can be affected by factors outside its control. Consult with a tax professional before exercising stock options to find a strategy best suited to your particular needs.
