What Does it Mean to Exercise and Option?

Answer:
With an employee stock option, you have the right to

purchase or “exercise” a specific number of your employer’s stock at a stated price during a specific time period known as the “exercise” period. To exercise options, you can pay cash, trade employer stock you currently hold, or borrow money from a stockbroker – but you’ll need to sell enough shares to cover you your costs.

With a non-qualified stock option, a company is able to compensate employees without paying cash. The company gives the employee an option to buy shares of stock at a certain price - usually about the same as what the stock is trading for publicly. If not publicly traded, the employer determines share values on the date an option is granted. Because this is a type of compensation, “ordinary income” must be reported when the option is “exercised.”

When an option is “exercised” for qualified or “incentive” stock options, no income is reported. In fact, the total gain when the stock is sold can be taxed as long-term capital gains. Because of specific tax implications it is advised that you contact your tax attorney.