How Non-Qualified Stock Options Work

My wife works in a management position at a local biotech startup and in that role she’s granted non-qualified stock options from time to time. I wrote about pre-IPO stock options over two years ago but since then she’s received “post-IPO” non-qualified stock options. Since it’s getting to be the end of the year, I’m doing some research as to how the capital gains works and it turns out that stock options are pretty easy to understand.

First, there are incentive stock options and non-qualified stock options. There are several differences but the one that really matters is how they are taxed. This article will focus on non-qualified stock options, non-qualified referring to how they are not qualified for special treatment (incentive stock options are treated differently).

How my wife’s stock options work is that she’s awarded X shares, say 1000 shares, at a grant price, say $10.00, on a certain day. The shares vest over a number of years, say 4 years. So next year she gets 250 shares at $10, the year after she gets another 250 shares at $10, etc. She currently has the options but she can’t exercise them until they vest. That’s the basic vocabulary.

How are these taxed? When you exercise the option, 250 shares at $10, you are immediately taxed on the difference between the market price and your exercise price ($10). If the market price is $12 when you exercise, then you will immediately be taxed on $500 ($2 x 250 shares) of capital gains. You can hold the shares, you can sell them, but you are already on the hook for $500 of capital gains. From there on for tax purposes, it’s as if you bought the shares at $12.

When Should You Exercise Your Options?

So I had this chat with my wife and the first thing she thought of was to exercise the stock options when the stock is at its lowest value. On the face of it, it seems to make sense. The smaller the difference between your grant price and the market price, the less you are taxed. However, you earn less too. It doesn’t matter which tax bracket you are in, you are taxed less than what you earn. In the highest tax bracket of 35%, you keep 65 cents on the dollar; you want the price to be as high as possible before you exercise. The key is to maximize income, not minimize tax.

In reality, you balance your need for the money with the market price of the stock. You always want to exercise at the highest price possible but you have to balance that with whether you need the money or when the options expire. When you exercise, you want to sell immediately. There is no benefit to holding onto the shares. If you wanted the shares in the first place, you could’ve bought them on the open market. By keeping your shares, you run the risk of being taxed on income you will never realize.

This is all based on my own web research, I’m not a tax professional so please consult with a tax accountant or attorney before making any decisions.


Predicting Federal Reserve Rate Changes

Do you ever read the news or watch television and wonder what those speakers mean when they say “the market predicts the Fed will [increase rates/cut rates/do nothing]?” I have.

What they are referring to is the federal funds futures market where traders buy and sell options contracts linked to the federal funds rate. Unlike other options, where an actual asset could be delivered (an oil futures contract is actually a contract to buy or sell oil at a future date), the federal funds futures contract is a little different. Rather than butcher the definition, according to the Federal Reserve Bank of Cleveland:

A fed funds futures contract is an interest rate futures; i.e. a futures contract whose value is based on a fixed-income security or interest rate. The underlying interest rate for the fed funds futures contract is the average daily effective federal funds rate for the delivery month. The final settlement price for a contract is 100 minus this average rate.

When the market “predicts” the next Fed action, it’s really what the wisdom of the masses (the fed futures trading masses) believe, based on their trading actions, what the future federal funds rate will be in the delivery month of the option.

Where can you find this information easily? The Federal Reserve Bank of Cleveland’s Fed Funds Rate Predictions page! It’s updated daily and has tons of information (check out the excel spreadsheet you can download).

How can you use this? Outside of fun trivia, one way to take advantage of this is to avoid buying long term CDs if the prediction says the rates will go up and to buy CDs when the rates are going down. While the predictive ability spans only a few meetings in the future, it can give you a better idea if you’re deciding what to do. Of course, since everything is measured in probabilities, anything can happen.


S&P Futures vs Fair Value: -5.5, What Does That Mean!?

Yesterday I was telling one of my friends that the futures market for the Nasdaq and the S&P were down. He remarked that while he understood the idea of futures on a conceptual level, he didn’t really know what it meant when it said -14 or -12 S&P futures vs. fair market value. As I tried to formulate a response, I actually didn’t really know what the difference was. I did a little research into what those values meant and while I’m not 100% confident in my response, I wanted to put it on the site and hopefully you all can tell me I’m right or wrong.

S&P futures vs fair value: +4.8. Nasdaq futures vs fair value: +12.3. .

A futures contract is it’s an agreement to buy or sell something at a particular price on a particular date in the future. So in the case of the S&P futures, it’s a security pegged to the S&P’s performance and that’s what’s up for sale. A future is a lot like an option except with an option you have a choice in whether you want to exercise the option. With a future you are obligated to exercise it, so you are obligated to buy or sell that security on the particular date.

What does it mean when the future is priced at 5.0? I believe each futures contract is for 100 units (option contracts are like this) and the price is specified in units, so that means to buy the futures contract you would need to pay $500. When you say that the S&P futures are trading at -14 to the fair market value, that means, after you factor in interest and dividends, a contract is selling for $1400 than the fair market value of the contract.

Ultimately, what can I do with this information? I’m not entirely sure other than the general notion that investors believe the market will go down. If they are trading for above fair market value, then in general investors believe the market will go up. I don’t think you can read anything other than a general notion from those values, even if you compare them, because there are so many other factors. For example, pre-market yesterday (Monday 22nd October 2007), the futures were down in the negative low teens and the market ended up for the day after being down to start.

If you have an experience or information to share, please do, I’m a complete novice in this and would love to hear from some more experienced folks out there.


Introduction to Pre-IPO Stock Options

I’m not an investing guru, I dispense no professional advice, and the only investing training I have is from the University of Google where classes are available 24/7. That being said, I recently had a chat with my girlfriend who was being compensated, in addition to salary, in the form of pre-IPO shares in the company she’s currently working for. Having little to no understanding of the terminology of options, let along pre-IPO stock options, I had to seek an education.

Here’s how it works, you get hired and they give you a option grant – a document that says how many shares you can buy and for how much. The strike price is the price at which you can purchase the shares. The grant date is the date you officially begin vesting and should be on that option grant sheet.

Capital Gains

You have two dates to remember, the grant date and the exercise date. The exercise date is the date you purchase the shares from your option.

If you sell your shares within two years of your grant date or one year of your exercise date, it is called a disqualifying disposition and your earnings will be treated as income. If you sell within one year of your exercise date, it will be considered short term capital gains – taxed at your marginal tax rate.

Lockup Expiration & Blackout Periods

A lockup is a period of time after an initial public offering when pre-IPO shares can’t be sold; check how long you’ll have to wait after the IPO before you can sell your shares. A blackout period is a period of time, usually around earnings announcements and the like, where you can’t trade your shares either. There is an SEC mandated 3 day waiting rule for trading after announcements too.

Okay, now the vocabulary lesson is over…

Evaluating How Rich You’ll Be

You are not rich. Options are worth nothing in an IPO, just ask all the dreamers from the dotcom era, but they have potential to earn something. How can you figure this out? You really can’t unless you have a crystal ball but if you just ballpark how companies in your industry are faring, how you compare to them, you might be able to ballpark a share price if you know how many shares your company plans on IPO’ing with.

Get everything in writing

This is sage advice for everything. Make sure that option grant explains everything, the schedule your shares vest, what happens in a buyout, etc. because while the intentions might be good when the company is performing well, people can get real ugly when the ish hits the fan.


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