Whether you’re getting started with options trading or you’ve taken company stock options as a form of compensation, there is probably one question plaguing your mind more than any other: when to exercise stock options. And fortunately for you, you’ve come to the right place. In this article, we’re going to explain when you should exercise your stock options depending on the type of options contract in question. We’ll also guide you through how to exercise stock options when the time comes.
As you’ll soon discover, timing is everything in terms of when you exercise stock options. It can be the difference between coming out on the right side of your contract with a hefty profit or making a loss. Beyond profitability and risk management, the timing of when you exercise your options will affect your tax implications, too. There is definitely a lot to consider – but we’re going to clear it all up for you and simplify this complex topic.
First things first – let’s start by explaining what stock options are, and the different types of options there are.
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What Exactly Are Stock Options?
In this section, we’ll give you a quick breakdown of what stock options are and how they work. In the previous link, you’ll find our complete guide on the matter. If you’re new to options trading or just want a refresher, we highly encourage you to click through and read the discussion. It will teach you all you need to know to begin trading options – or taking stock options as a form of employee compensation.
Simply put, stock options are a contract you can buy as an investor. These options contracts give you the right to buy or sell the company stock at a predetermined price, in a predetermined quantity, before or on a predetermined date. As mentioned, there are two types of options contracts: puts or calls. These vary in their terms. A call option gives you (the buyer of the contract) the right to buy stock. A put option, on the other hand, gives you (the buyer) the right to sell stock.
When you purchase a call option, you are banking on the stock rising beyond the strike price (your predetermined price). Thus, when you exercise your option, you’ll be buying that stock at discount. Similarly, when you purchase a put option, you are banking on the company stock falling below the strike price. When you exercise this option contract, you are selling the stock back at a premium. Before we go any further into our discussion of when to exercise stock options, let’s discuss employee stock options vs trading stock options on the stock market.
Stock Options As A Form Of Employee Compensation
When starting a new job, you may be offered incentive stock options as part of your compensation package. This is especially common in startups where capital for wages may be limited. Companies love giving these out because it helps incentivize employees to raise the company’s stock.
However, you are a bit more limited in exercising stock options through your company because there is usually a vesting period. This is typically a year or longer – and your options are not fully vested until this period is up. That means if you quit or are fired before the vesting period is up, your company stock options dissolve.
When it comes to company stock options, you also need to understand how these affect you from a tax perspective. More on that later. For now, let’s talk about trading stock options in the market independently.
Options Trading In The Stock Market Independently
With company stock options, you are obviously only worried about your specific company’s stock. However, when trading in the stock market, the options available are endless. You can trade stock options for any company – or you can trade options for specific commodities. And there is no vesting period to be concerned with – only the exercise date when your options contract expires.
With this style of options trading, you are more concerned with maximizing profit potential and minimizing risk than you are with the taxation side of the equation. If you want to learn more about this tactic, check out our complete breakdown of swing trading options in our blog. We’re going to start getting into the topic at hand – why does it matter when you exercise stock options?
Why Does It Matter When To Exercise Stock Options?
There are a few reasons that the timing of when you exercise your options matters so much. First and foremost, you want to make a profit. That is the whole point of investing. If you have the opportunity to exercise your options (or sell your contract) while you’re in the money, you may want to do it. If you wait, you could risk losing that profit and potentially coming out on the wrong side of the equation.
But beyond just maximizing profit and minimizing risk, it is important to understand how the timing of your exercise date affects your tax liability. You can time your exercise date to enjoy favorable tax treatment.
When To Exercise Employee Stock Options
While most of our readers are likely here to learn about when to exercise exchange-traded stock options, we’re going to start by discussing when to exercise employee stock options. While you will obviously have to wait until the vesting date has passed, at what point after that does it make sense to cash in on your options? Keep in mind that some employee stock options will have an expiration date too – just like exchange-traded options contracts. This is usually 10 years.
Wait Until You Are In The Money
Let’s get one thing out of the way – it only ever makes sense for you to exercise your options if they have value. If you don’t stand to gain anything from exercising your options, why would you? So, wait until you are in the money (meaning your exercise price is favorable compared to the market price).
Say you were brought on board and offered options at a strike price of $5 a share. Over the past 5 years, your company has grown leaps and bounds. And today, the market share price is $30 a share. You can buy your company’s stock at a serious discount – and then turn around and sell the shares on the market for profit or continue holding if you truly believe there is more potential in your company.
Consider Exercising & Selling Into Strength
Of course, you don’t have to buy or sell all of your options at once. As we discussed in our article when to sell swing trading, you can sell a chunk of your shares while you’re in the money to earn some profit – holding another chunk in hopes of realizing greater profits in the future.
And, because you’ve already cashed in on a percentage of your options, your risk is much lower. If you sell off 75% of your stock while you’re in the money, and you start to see a reversal in your company’s stock price – you can sell off the remainder of your shares and still come out on top. This is known as selling into strength.
How Will You Be Affected From A Tax Standpoint?
One other important thing to consider is your tax liability. The type of tax you have to pay is determined by the type of options you’re exercising and when you exercise them. Our in-depth guide on how stock options are taxed is a great resource if you want to learn all about taxation as it pertains to options. However, we’ll summarize the important pieces for you here:
There are a few different types of tax implications you must consider – ordinary income tax, alternative minimum tax, and capital gains tax. Depending on the type of your options (NSOs vs ISOs), you may have to pay varying taxes. First and foremost, consider where exercising your options in the current tax year would put you from an income standpoint. If supplemental income from exercising your options could place you in a higher tax bracket for the year, it may make sense to hold off.
At least, that is the case with NSOs. ISOs (incentive stock options), on the other hand, are not taxed when you exercise them. You only pay tax upon actually selling the shares you buy.
Does It Make Sense To Exercise Your Stock Options Early?
One final point we want to discuss in terms of employee stock options is early exercise. This isn’t something every company allows, but if yours does, it may be tempting to pull the trigger. Should you do it? Here is what you should consider.
While you can pay to purchase the shares early, you cannot do anything with them until your vesting period is up. We know what you’re thinking – what is the point of exercising early then? Well, by exercising early and holding your shares until the vesting period is up, you start the clock on your ISOs to qualify for favorable tax treatment. And as you now know, the taxation element is an important consideration as to when you should exercise your options.
When To Exercise Stock Options You’re Trading Independently
We’ve covered everything employees need to know about when to exercise their nonqualified stock options or incentive stock options – but what about traders who are hoping to learn about exchange-traded options? If that sounds like you, keep reading. Because we’ve got good news for you – the ideal time to exercise your options contracts can be made far more simple. There is obviously no vesting period – you just need to be sure to either sell your contract or exercise it before the expiration date.
And, while you do need to consider the tax consequences of exercising your options, you’re going to be more concerned with profit. Is your contract currently in the money, and do you want to capitalize on it? Then exercise your options and get your profit – simple, right?
But wait – what if the market price continues to trend in your favor? The last thing you want to do is cash out early and miss out on an additional 5%, 10%, etc. This is true, but you also have to consider the alternative – what if the market price reverses and you start to watch your profit dwindle? This is why we highly encourage all investors to invest in themselves and their craft. A quality stock forecasting software will help you determine if a reversal is on the horizon so you can exercise your contract at the perfect time – limiting risk and maximizing profit. More on that later – for now, let’s discuss how to exercise stock options when you decide the time is right.
How To Exercise Stock Options When The Time Comes
So you’ve determined the time is right to exercise your stock options – how do you go about it? There are a few approaches you can take depending on your goals. One approach is to exercise your contract and buy the company shares for the purpose of immediately selling them back on the market. This will get you your profits right away. Or, if you see more potential in the company or commodity in question, you can exercise your options contract and continue holding the shares long term. Either way, here are some things to consider:
How Much Will Exercising Cost You?
One thing new options traders tend to forget is that exercising your options contract costs money. You need the capital to purchase the shares themselves. Think about it like this – the average stock option contract is sold in lots of 100 shares. So, if you bought a contract where the strike price is $25 a share and you decide you want to exercise, you’ll need the $2,500 on hand.
But that $2,500 doesn’t even include the tax liability of exercising your options contract. You must consider whether you’re working with ISOs or NSOs. Incentive stock options will require you to pay the alternative minimum tax the following year. Meanwhile, nonqualified stock options are taxed as ordinary income tax the same year. And if you’re exercising options through your company, those taxes will be withheld by the company at the time of exercise. Once you’ve pondered the cost aspect, it’s time to consider what route you’re going to take.
3 Choices When Exercising Your Options Contract
We explained the two main choices above – holding your new shares as a long-term investment or quickly selling them on the market to earn a profit and cover your costs. But there are two other options. Let’s compare them all below:
- Exercise & Hold Your Shares – if you expect that the current market price is going to continue rising, exercising and continuing to hold your shares is a great long-term play. You’ll need the cash on hand to cover the cost – and you’ll need to be comfortable not getting that cash back immediately. You also need to be comfortable with the risk that comes from holding these shares with no guarantee that the stock price will rise further.
- Exercise & Sell To Cover Costs (Holding The Remainder) – if you want to at least cover your costs, you can sell just enough of your shares to do so. Then, hold the rest and hope for an increase in stock price beyond your exercise price for further profits.
- Exercise & Sell All Shares – if you just want to earn profits from your options, you can exercise and sell all your shares right back on the market. This is typically our recommendation if you are not looking for long-term investments, but rather, are trading options contracts for supplemental income.
Final Thoughts On How & When To Exercise Stock Options
There you have it – all you need to know on how to exercise stock options and when to exercise stock options. There are varying recommendations depending on if you’re trading options contracts on the market or taking employee stock options as part of your compensation. You’ll need to consider the cost of exercising your options, the tax consequences of doing so, and much, much more. But, we hope this in-depth guide cleared up a few things for you.
If you want to learn more, we recently wrote a complete guide on how to trade stock options – this is a great resource if you’re looking to hit the ground running with options trading. But to really set yourself up for success, take a look at the Options Paycheck Experience. This is the #1 course for new options traders online.
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