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Ask The Expert: My Employer Offered Me Stock Options -- What Should I Do?

Each week, one of our investing experts answers a reader's question in our InvestingAnswers' Q&A column. It's all part of our mission to help consumers build and protect their wealth through education. If you'd like us to answer one of your questions, email us at editors@investinganswers.com and include "Investing Q&A" in the subject line. (Note: We will not respond to requests for stock picks.)

If you work for a publicly traded company (or a private company that may eventually go public), then you may be eligible for stock options. Yet many employees -- including our reader who sent in this week's question -- aren't sure how to handle them.

Question: I've recently been hired by a company that offers stock options -- something I have zero experience with. What do I need to know before deciding the best move to make?

-- Beth in Gonzales, Texas

The Investing Answer: Well, that's a great gesture that your company has made to its employees. With a little luck, this stock options grant may generate a tidy windfall for you.

Much of that depends on how your company grows in coming years (and how its stock price performs), although your ability to profit from these stock options will also greatly hinge on the broader stock market. If the market rises in coming years, there's a good chance you'll do well with these options. But a falling market, as was the case early in the 2000's and again in the late 2000's, may make it hard for you to profit.

But we're getting ahead of ourselves. Let's first look at how these work and what steps you need to take.

In addition to traditional forms of compensation, a company can provide an extra benefit to employees through the granting of restricted stock or stock options. Restricted stock is an actual gift of shares that you can slowly cash in with each passing year of employment. These never expire, and once they are vested -- meaning the noted time frames have been met for you to own them -- you can instantly turn them into cash or transfer them into your own brokerage account.

But in your case, Beth, we are talking about stock options. Those aren't quite as generous.

Here's how stock options are defined in InvestingAnswers' Financial Dictionary:

"Employee stock options (ESOs) are call options on a company's common stock granted to a select group of its employees. Certain restrictions on the option provide a financial incentive for employees to align their goals with those of the company's shareholders." (Click here to see the complete definition, including how it works and why it matters.)

Stock options are issued (typically in increments of 100, 1,000, 5,000, etc.) at the same price that the company's stock currently trades. Let's assume you have been given 3,000 stock options (with a three-year vesting period), and your employer's stock trades at $10.

After the first year, one-third of these options (or 1,000 shares) will have vested, which means you have the right to buy that many shares at the price shares traded at when they were first issued. If the stock has risen to $20, then the $10 a share increase means you are able to capture a $10,000 profit (1,000 vested shares x $10 price increase).

In theory, you would be asked to come up with $10,000 to buy the 1,000 shares (at the former $10 price) and would then own $20,000 worth of stock. In reality, most employers (or the stock transfer service they use) will front the money, making this a cashless exercise.

The same math applies for the second and third year, enabling you to capture the difference between the original $10 stock price and the current stock price for each of the next block of 1,000 shares. Note that in most instances, any unvested options will have no value if you leave the company.

The "Catch" That Comes With Stock Options

Yet here's the catch. Stock options have a finite shelf life and will eventually expire worthless. So you need to know about these expiration dates and be sure to convert options into actual shares before they expire.

Your employer won't track this, so it's up to you. Many employees choose to convert options into shares as soon as they are eligible to avoid the risk of forgetting to act in time. Once you've done so, there is no need to take any further immediate action. If you think your employer has a great future, there's no reason to sell the stock at that time.

Converting options into stock may have certain tax implications for you. Every case is different, and it's wise to talk to your accountant to determine the best way to handle the taxes. In some instances, employees choose to wait a short time into the following year if it makes sense for tax planning purposes.

Also, talk to your human resources department to gather all of the facts pertaining to your employer's stock options program. No question is too mundane.

Lastly, it may be wise not to discuss too many details with fellow employees.  They may not have gotten the same generous options grant, and they will likely feel jealous that you have been so kindly rewarded.

No Chicken Counting

It's unwise to obsessively follow your company's stock price, measuring your potential gains (or losses) on a daily basis. I made that mistake in the late 1990's as my employer's stock price soared in value. These options hadn't yet vested, but their value at one point exceeded $200,000, and I recall walking down the street planning on how I was going to spend all that money.

Of course, the dot-com boom ended quickly, and my paper profits vanished into the air.

To paraphrase the old saying, "Don't count your options before they're vested."