How to Exercise an Option: A Step-by-Step Process

A stock option grants the right, but not the obligation, to purchase a company’s shares at a predetermined price. This right is a form of equity compensation, often provided to employees. Exercising an option means utilizing this right to buy shares. This article guides you through understanding and performing this action.

Key Information Before Exercising

Before exercising, gather details about the option grant. Understand the strike price, the fixed price per share at which you can purchase the stock. This price is set when granted and remains constant, directly impacting exercise cost.

The number of vested options is important. Vesting is the process by which an employee gains ownership rights over time or by meeting conditions. Options typically vest over a set schedule, meaning you earn the right to purchase them gradually. Only vested options can be exercised.

The expiration date is the final date to exercise options; after this, they become worthless. Companies often have a post-termination exercise period, usually around 90 days, during which vested options can still be exercised after leaving. Understanding the option type, such as Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs), is necessary, as it influences tax implications.

The current market price of the underlying stock indicates potential profitability. If the market price is higher than your strike price, your options are “in the money.” If the market price is below the strike price, your options are “underwater,” likely resulting in a loss. This helps determine if exercising is financially advantageous.

Financial readiness involves having sufficient funds to cover the exercise cost, calculated by multiplying the strike price by the number of shares. This cost can be substantial, and additional funds may be needed for fees or initial tax withholdings. Access to a brokerage account or the company’s stock plan platform is a prerequisite for exercising options.

Exercise Methods

Once information is understood, individuals can choose from several common methods to exercise their stock options.

Cash Purchase (Exercise and Hold)

The cash purchase, or “exercise and hold,” involves paying the full strike price in cash for the desired shares. This requires a direct cash outlay to cover the purchase price and any immediate taxes or fees.

Sell-to-Cover

The sell-to-cover method is a cashless exercise. A portion of the shares acquired are immediately sold to generate funds for the exercise cost, applicable taxes, and brokerage fees. The remaining shares are then delivered to the option holder. This method eliminates the need for upfront cash.

Sell All (Same-Day Sale)

The sell all, or same-day sale, method involves immediately selling all acquired shares in the open market. Proceeds cover the exercise cost, taxes, and fees, with the net cash delivered. This method provides immediate liquidity, as the individual receives cash rather than shares.

Each method carries different implications for cash requirements and share ownership. Cash purchase results in full ownership but demands significant upfront capital. Sell-to-cover allows exercising without personal cash but results in fewer shares retained. Same-day sale provides immediate cash but means no shares are held. The choice depends on an individual’s financial situation, tax considerations, and investment goals.

Steps to Exercise

Contact your brokerage firm or the company’s stock plan administrator to begin. Many provide online portals to manage and exercise options directly. Some may require a phone call or physical form submission.

When using an online platform or form, input the number of shares and your chosen exercise method (cash purchase, sell-to-cover, or same-day sale). The platform will guide you through selections, calculating costs and potential proceeds.

Review all details before finalizing the request, including the number of options, selected exercise method, and estimated financial outcomes. Once reviewed, submit the request via an online portal or by mailing a form.

Timing of submission can be important, especially near an option’s expiration date or during company blackout periods. Most brokers require instructions by a specific cut-off time on the day of exercise. After submission, the request is processed, leading to the acquisition of shares or cash.

After Exercising

After an option exercise is completed, acquired shares typically appear in your brokerage account. The settlement period for stock transactions is generally two business days (T+2). The chosen exercise method determines if you receive shares, cash, or a combination.

Initial tax implications vary by option type. For Non-Qualified Stock Options (NSOs), the difference between the fair market value at exercise and your strike price is ordinary income. This amount is subject to income, Social Security, and Medicare taxes, and is reported on your W-2. Employers may withhold these taxes.

For Incentive Stock Options (ISOs), there is generally no regular income tax at exercise. However, the “bargain element”—the difference between fair market value at exercise and strike price—may be subject to the Alternative Minimum Tax (AMT). This can result in a tax liability even if shares are not sold immediately.

Holding period for capital gains begins on the exercise date for acquired shares. For long-term capital gains, shares must be held for more than one year from the exercise date. This holding period is distinct from the option’s original grant date. Retain all confirmation statements and documentation for accurate tax reporting.