Stock options give you the right to buy and sell shares at a predetermined price. You can contract to buy stock options, or you may receive options on company stock as part of your employee compensation. You exercise your option when you use it to make a stock trade for the agreed-on amount.
Exercising stock options refers to purchasing a number of shares your employer has contracted to offer you at a specific selling price within a given timeframe. You might do this with cash or exchange existing stock you own.
Strike Price Definition
The strike price or exercise price is the figure the option allows you to trade at. Once you take out an option, the strike price is guaranteed until the option expires.
Call options allow you to buy at the strike price, while put options let you sell. If you're taking out an options contract, the contract price is based on the strike price. A call option with a strike price of $25, for example, costs more than an option with a strike price of $75.
How to Exercise Your Options
The simplest way to exercise your stock options is to pay cash. Suppose you have an option to buy 500 shares at $20 and the stock sells at $60; you pay $10,000 and get shares worth $30,000. If you don't have enough cash to afford the brokerage fees and taxes as well, you may be able to trade your company $10,000 worth of shares you already own. Another alternative is to borrow from your broker to buy the stock and then reimburse him with some of your new shares.
Risks of Exercising Your Options
One risk of exercising your options is that your timing might be off. A week after you exercise a call option, the stock could double in price; if you'd waited to exercise, you'd have made more money.
A bigger risk is that the stock does the opposite of what you expect. If you take out a $20 buy option for 1,000 shares but the stock crashes to $5 before you exercise it, you wasted your money buying the option. It's less of a loss, however, than if you bought the stock.
Other Stock Option Considerations
Your options are worthless if you don't exercise them before they expire. If the stock keeps going up, waiting until right before the option expires gives you the most bang for your buck. If you see danger signals about the stock, exercising your options quickly is safer.
During the 1990s tech-stock bubble, some Silicon Valley employees exercised their stock options early and then sold off the shares they bought. When the tech bubble collapsed, they had cash instead of a pile of suddenly worthless options.