A stock option is a contract which allows the holder to purchase stock at a fixed price, typically known as the “exercise price”.

There are two classifications of employee stock options: (1) statutory or qualified options (i.e. the tax treatment of the options is governed by specific Internal Revenue Code Sections) and (2) Nonqualified stock options (i.e., stock options that do not meet specific requirements in the Internal Revenue Code for special tax treatment).

There are two types of qualified stock options: Incentive stock options (ISO) and options written under the employee stock purchase plans (ESPP)

- Tax Implications of Exercising Qualified Stock Options -

Generally, an ISO allows the grantee to postpone taxation of option gains until option shares are disposed of, at which time the gain will be taxed at favorable capital gains rates.

- Employee Stock Purchase Plans (ESPP) -

Employee stock purchase plans are written, shareholder-approved plans under which employees are granted options to purchase shares of their employer’s stock or the stock of a parent or subsidiary corporation for not less than 85% of their fair market value.

If the option price is less than the fair market value of the stock at the time the option is granted, the employee recognizes ordinary income in the amount of the lesser of (1) difference between the fair market value of the shares when sold (or the fair market value of the shares at the employee’s death while owning the shares) and the option price for the shares or (2) the difference between the option price and the fair market value of the shares when the option was granted. The balance of the gain is treated as capital gain.

- Tax Implications of Exercising Nonqualified Stock Options -

Typically, income is recognized at the time an employee exercises nonqualified options. The amount included as taxable compensation is the fair market value (FMV) of the stock on the exercise date, minus the amount paid (exercise price). Compensation is reported to an employee in box 1 of form W-2 and in box 12 with a code “v.” Income and employment taxes are withheld on this income. For our purposes, let’s assume that you receive options for stock that is actively traded on an established market such as NASDAQ, but that the options themselves aren’t traded. With this type of option you must recognize taxable income equal to what’s called the compensation element when you exercise the stock options and purchase the stock.

- Compensation Element Defined -

Your compensation element is basically the amount of discount that you get when you buy the stock using your options. It’s calculated as (market value – stock grant price) x number of shares you buy

The market value of the stock is the stock value on the date you exercise the options (i.e., the date you buy the stock under your option agreement).

The stock grant price is the amount that you can buy the stock for per your option agreement.

Your employer is required to report the compensation element on your Form W-2 for the year you exercise the options.

- Restricted Stock Awards -

Unlike options, which may or may not be exercised, restricted stock awards put shares into the grantee’s name up front, subject to forfeiture during the period of restriction. Any price paid by the grantee is typically well below market (if the shares are newly issued, state corporation law may require a payment equal to par value), and when the restrictions lapse the grantee will have gained something even if the market price has fallen. The nature and duration of the conditions attached to restricted stock can be specifically tailored for each grantee. In many cases, the condition is simply continued employment for a specified period.

- Tax Treatment of Restricted Stock Awards -

The excess of the restricted stock’s market value at the date when the risk of forfeiture or restrictions on transferability lapse over any price paid for the stock is treated as compensation income to the grantee, and any subsequent change in the value of the shares will be recognized for tax purposes as capital gain or loss upon disposition of the shares.

- Section 83(b) Elections -

In the alternative, the grantee may elect under I.R.C. § 83(b) to recognize compensation income at the time of the initial transfer of the shares, based on the value of the shares at that time (rather than at the time of vesting). No income will be recognized upon lapse of the risk of forfeiture or restrictions on transferability and subsequent appreciation or depreciation will be recognized as capital gain or loss. The grantee will not be entitled to any loss deduction if the shares with respect to which a § 83(b) election was made are later forfeited.

- Conclusion -

Stock options can be a great way for employers to increase the compensation package of their employees and a great way for employees to invest in their employer. Just remember that there are numerous tax effects that vary based on the type of option. Be sure to check with your Tax Coach whenever you receive the opportunity to acquire an option in your company.

Let’s be clear on this. There is no other option trading strategy that can outshine or even equal the profit generating potential of the sport of writing naked options. The term ‘sport’ is used here because those who practice this money making trading technique not only turn out fabulous profits but also have fun in the process. It is a fun, profitable but dangerous option trading sport that is mostly played by seasoned and skilled option players. That is, until the sport’s peril’s were tamed with the use of trading techniques that, while offering substantial safeguards to the player, still continued to offer high profitability ratios, albeit at slightly reduced rates. Having made it ‘investor safe’ has only slightly altered the profit potential of writing nakeds and certainly, without doubt, continues to be the premiere money making trading strategy in the options market.

 

The birth of the options market in recent decades spawned the creation of dozens of trading strategies and systems that is today being used not only by individual options traders but also by financial institutions. Stock options as an investment instrument is now widely employed as a safe and sound money strategy. The ability of options to give the investor a wide range of choices in stock market investment is what has made the options market grow by leaps and bounds over the last two or three decades. There are dozens of option trading systems being employed by individual investors as well as financial institutions. Each system is designed to accomplish a specific investment goal. A financial institution may use long put options to hedge its winnings in stocks that have appreciated in value, another investor may buy call options instead of stocks to enter a position in a security that has caught his fancy. Still another may sell calls against his stock holdings to generate income from his stock position, or what is now popularly known as covered call writing.

 

Trading strategies, techniques and systems available to the option trader are so numerous today that it would take a whole book to describe each and that would be just a brief description not a detailed explanation. It would be far beyond the scope of what we could cover in this short article. Most of the strategies are based on the principle of buying calls and puts or, variations of this strategy such as the use of spreads. The reason for the popularity of buying calls and puts and its variations is quite simple; limited or defined loss against the potential for unlimited and fabulous profits. This is what has driven thousands into the options trading game. But like everything else in life there is always a trade off. While the potential for fabulous profits against limited investment exists the reality of achieving such success is restricted. It’s almost like buying a lottery ticket with the potential for winning fabulous riches. Or putting it differently, it’s also akin to going to a casino and placing bets on gaming tables with the hope that at the end of the evening you will come out with more money than you came in. As we all know there are very few winners in casinos and that is why the gaming business offers tremendous profits for the operators.

 

But one can be an option trader and be in a similar position as the casino operator.  How? By being an option writer or seller instead of a buyer. For every option that is bought in the market, there must be a seller or writer of the option. These writers are the casinos in the options business. As the option seller you take the bets from the option buyers and since 75 to 80 percent of all options in the market expire worthless, you the seller pocket the premiums paid by the buyers when the options they bought expire worthless. For the benefit of those who are not familiar with gambling casinos, the winning odds of casinos over the betting player is only around 5 percent and yet they rake in profits from this business. Now imagine this, research and studies have shown that the option writer (seller) has better than 10 to 20 percent odds over the option buyer.

 

Option traders who successfully use the strategy of selling options consider themselves as having found the Holy Grail of Investments. And of all the variations in option selling strategies (just as many as there are in option buying), writing naked options is considered to be the Cadillac division. No other option selling system offers the profit potential of the naked writer.

 

So why aren’t there more option writers in the market? For two reasons:

 

 

 

 

 

It must be noted however, that option writing is fast gaining popularity among serious investors looking to grow their wealth at a steady, consistent and secure manner regardless of market or economic conditions. For those willing to venture into this lucrative field for long term capital appreciation don’t let the first reason above frighten you into inaction. There are many ways one can protect himself and conquer the element of ‘unlimited loss’ in writing nakeds. The author of this article is one of many successful naked option sellers. He has put out an e-book detailing a trading system that uses a three pronged strategy that trounces the so-called risk of loss to be almost neglible. Information about his system can be found at his web site.   

 

 

 

This means that at any given moment in time, you might have a different opinion of the potential movement of that stock. Knowing this, there is a way to address your present level of confidence or “lean.” You do this by your choice of which option you sell.

While it is true that the at-the-money option has the most amount of extrinsic value, it might not always be the ideal option to sell in every situation.

For instance, if you feel that the stock itself has a very high chance of producing capital appreciation above the potential amount of premium you could receive from selling an at-the-money call, then sell an out-of-the-money-call so you can allow yourself a little more room to the upside on the stock.

For example, let’s say the stock is trading at $27.00. Normally, you would sell the 27.5 calls at say $1.00. If the stock were to rise quickly and eclipse the $28.50 mark, then with the buy-write strategy, your position would have maxed out at $28.50, and you would have a $1.50 one month gain. Not bad, but if the stock went to $29.50 then you would have missed out on another $1.00 profit. However, if we had sold the 30 calls for $.30 then we would have another outcome. You bought the stock at $27.00 and sold the 30 calls for $.30 and the stock goes to $29.50.

You would have made $2.50 in capital appreciation and $.30 in option premium for a total of a $2.80 return.

So, if you feel the stock has a real good shot at taking a run up, you can lean your position long by selling an out-of-the-money call.

If you have a more neutral view on your stock you would sell an at-the-money-call in order to receive a bigger premium which allows for greater downside protection if the stock trades down and higher potential profit if the stock becomes stagnant.

This strategy also works on the downside. If, by chance, you feel that the stock may trade down a bit during the life of the option, then you can sell an in-the-money-call. The effect of this would be to provide you with a little extra premium to cover more downside risk.

Remember when you sell an option you seek to capture extrinsic value. An in-the-money option not only has extrinsic value but also some intrinsic value.

When you feel that you want to lean your covered call strategy (buy-write) a little short, choose to sell an in-the-money call so you can also have some intrinsic value to cover your downside.

As an example, say your stock is trading at $29.00 and you feel that your stock may trade down a little but still remain in an uptrend cycle. You don’t want to get rid of the stock but you also don’t want to lose any money so you sell the 27.5 call at $2.00.

The stock starts to trade down and finishes at $26.00. If you had owned the stock naked, then you would have lost three dollars since you owned the stock at $29.00 and it closed at $26.00 on expiration.

However, because you sold the 27.5 calls at $2.00, you would only realize a $1.00 loss in the stock. The premium received will offset the loss due to the fact that you identified and adjusted for a likely move.

As you can see, the buy-write strategy can be altered to fit any directional view you have on your selected stock.

Finally, if you intend to use the buy-write strategy successfully, you generally need to sell the calls against your stock on a consistent, recurring interval, over a period of time.

This means that you will have to be prepared to “roll” your calls out to the next month come expiration. Sometimes, all you’ll need to do is to sell the next month out call.