How to Exercise Stock Option Incentives
Stock option incentives are given to senior employees by corporations as a reward or motivation for good performance. Better known as employee stock options, they come in two forms: non-qualified option and incentive stock option (ISO). Both types are much like the call options traded on exchanges. As with traded options, the option owner has the right (but no requirement) to buy a specified number of shares at a preset price called the strike price until the expiration date of the option. However, an ISO can qualify for capital gains tax rates while a non-qualified option cannot, provided you follow the regulations governing how ISOs must be exercised. Non-qualified stock options are covered in Steps 1 to 3 and ISOs in Steps 4 through 6.
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Instructions
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1
Exercise a non-qualified (also called non-statutory) employee stock option incentive when the market price of your company's stock has gone up. An employee stock option has no value while the market price is below the strike price (since you can buy the stock for less on the open market). If the stock goes up in value, take your option to your broker and instruct him to buy the shares and then resell them at the market price. You keep the difference.
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2
Cash in a non-qualified stock option with a cashless exercise. If it's not convenient to come up with the money to actually buy the shares needed to exercise the option, this is a popular alternative. Take your options to your broker. The broker will lend you the money to buy the shares, purchase them for you using the stock option and then sell the shares on the market. The broker then keeps the money you borrowed and deposits your profit in your account (minus a commission, of course).
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3
Reload your non-qualified option if your employer gives you this choice. A "reload" means that you are issued new employee stock options to replace the ones you just exercised, with the same terms, except the current market price becomes the strike price. That way, if the stock continues to appreciate you can still make more money, but by exercising the options and then reloading them, you protect gains already made.
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4
Wait at least one year before exercising an ISO. This is one of several rules that apply to ISOs that you must follow to qualify for the capital gains tax rate. An ISO must be issued with a strike price no greater than the market price at the time of issue, and you must remain an employee of the company or its subsidiaries.
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5
Hold the stock you've bought by exercising the ISO for at least one year. This is the other major rule that makes ISOs different from non-qualified options. You have to actually purchase the shares and keep them (so you can't do a cashless exercise). At the end of one year, sell the shares. You will be taxed only at capital gains rates on the difference between the strike price and the sale price.
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6
Protect the value of the shares you buy with an ISO during the year you must hold them with a put option. To do this, purchase conventional put options on the market with a strike price set at the market price. Put options give you the right to sell shares at that strike price. If your shares fall in price, the put option will protect your earnings by gaining value as fast as your shares lose it. This isn't complete protection (earnings from the put option don't get the capital gains tax break), but it protects most of your paper profits from market risk.
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