Stock Option Basics

• An employee stock option plan is a contract between a company and its employees that allows the workers to buy shares of stock at a specific price for a certain period. For example, an option plan might let you buy up to 100 shares of your company's stock for $15 for the next year. If the value of your company's stock increases to $25 during the year, you can buy the shares for $15 and then sell them at the current price of $25 to make a profit of $10 per share. Buying shares of stock through a stock option plan is known as "exercising" the option.
  
  

Types

• There are two main types of stock option plans: nonqualified plans and incentive stock options (qualified plans). According to CNN, under nonqualified plans, you pay income taxes on the spread --- the difference between a stock's current market price and the price you pay to buy the stock when exercising an option. On the other hand, with qualified plans you do not pay tax when you exercise options. Rather the spread and any investment gains that occur after you buy the stock are taxed at the long-term capital gains tax rate as long as you hold the shares of stock for at least two years.
  
  

Benefits

• Employee stock options can be advantageous to workers since they offer the potential for significant profits if the value of a company's stock increases over time. This may help growing companies attract top talent without increasing the actual salary for a position. In addition, employees do not have to exercise options, so if stock prices happen to fall, there is no downside for employees other than the fact that they won't be able to exercise options to make a profit.
  
  

Considerations

• Deciding when to exercise stock options is a key to maximizing gains. If you exercise an option today but the company's stock prices go up by 10 percent before the end of the option period, you will have missed out on potential gains. On the other hand, if you wait to exercise options and share prices fall, you may miss out on gains. In general, if a company's stock has been trending upward over time, it is best to wait to exercise options until the end of the exercise period to take advantage of appreciation.