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What is an Out-of-the-Money Stock Option? Thumbnail

What is an Out-of-the-Money Stock Option?


Jennifer from Mountain View, California, asks: my company is offering out-of-the-money stock options. What are these?


We don't see these often, but out-of-the-money stock options are similar to other stock options. They have a grant date, vesting schedule, strike price, and expiration date. The difference is how the strike price is determined. The strike price for most stock options (i.e., non-qualified and incentive stock options) is set at the grant date. The strike price for out-of-the-money stock options is set at the grant date, too, but after being adjusted by a pre-determined percentage.

Example: Ganesh is granted out-of-the-money stock options with a 150% adjustment factor. The value of Ganesh's company's shares is $100 on his grant date. His out-of-the-money strike price is set, then, at $150. 

These are referred to as out-of-the-money because, at the grant date, the share value is less than the option's strike price. No one would pay to exercise an option by paying a strike price higher than what the shares are worth. 

Example: Ganesh wants to exercise his options during an open trade window to generate cash to make a downpayment on a home. However, the current value of the stock is $125. It would cost Ganesh $150 to have the option to buy a stock that is only worth $125.

If the share price climbs above the out-of-the-money strike price, the options are no longer considered out-of-the-money. Instead, the options are now in-the-money because shares can be purchased by exercising options with a lower strike price than the value of the shares. 

Example: Ganesh waits for the next open trade window to exercise his options. The share price has climbed to $200 per share. Now, Ganesh has the option to purchase shares that are worth $200 for $150.

It's essential to seek out the advice of a tax professional when dealing with stock options because making a mistake can be costly. But the difference between the market value of shares on the date of exercise and the strike price is taxable as ordinary income.  One advantage of out-of-the-money options is that they can lower taxable income.

Example: Ganesh exercises another set of options when the share price is $150 per share. Since his strike price (which is Ganesh's cost basis) is $150, the difference between the value of the shares and the strike price is $0; thus, Ganesh has no ordinary income tax to report. If Ganesh's strike price was not adjusted by 150% at the grant date, his strike price would have been $100, and he would have had to report $50 as taxable income in the year of exercising.

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