What It Is

• Employee stock-option plans award employees contracts that give them the right within a designated time frame to purchase company stock at a stated strike price. If company shares rise in price, the employee can make a profit by buying the shares at the strike price and reselling them at the higher market price. The employee is not obligated to exercise the option--so if the stock does not go up in value, she can merely let the option expire.
  
  

How It Works

• A company will typically issue a non-qualified stock option with a required waiting period before the option can be exercised--a year is a common waiting period. After the waiting period, the company has the right to exercise the option at any time before the option expires. As an example, if a non-qualified stock option is awarded with a strike price of $20 per share and the company stock increases to $35 per share, the employee can exercise the option by buying the stock at the strike price and selling at market value, turning a profit of $15 per share. Profits are taxed as ordinary income in the calendar year in which the option is exercised.
  
  

Considerations

• The use of non-qualified stock options is especially popular among growth-oriented companies as a means to attract and retain talent. The employee gets a stake in the company's growth and the firm minimizes cash outlays for compensation packages. If share prices decline, a company might revalue the stock options by reducing the strike price.
  
  

Exercise

• Under a non-qualified stock option plan, the employee instructs a brokerage firm--usually contracted by the employer--to exercise the option to buy the shares and resell them. An employee would not need to raise cash to pay the strike price in what is known as a cashless exercise. The broker lends the money for the transaction, recovering it when the stock is sold and collecting a fee for the service.
  
  

Market Risk

• Non-qualified stock option plans do have some risk. The employee may exercise the option only to watch the stock continue to appreciate and miss out on additional profits. Some companies eliminate this risk by issuing new options when a non-qualified option is exercised. The new option might carry the same expiration date and terms but with the current market price as the strike price--so if the stock continues to rise, the employee can exercise the reloaded to reap the additional profits.