A few years ago on a Monday morning, I checked my brokerage account and to my surprise it showed that I had purchased 1,000 shares of AMD for a total cost of $15,000. The payment for this purchase was taken out of my brokerage money market account.

Why surprised you may ask. I had not put an order for this purchase nor did I really intend to buy AMD. I get to this in a little bit.

Had I wanted to sell the stock on that day, I would have received around $14,500, a loss of $500 in just a few hours. In the end it worked out and I sold that particular stock a few months later for a handsome profit.

But on that day I had a paper loss of $500 and if I didn’t have enough money to pay for the purchase, the $500 loss would have been the least of my worries.

So, how did I end up with a stock that I did not necessarily want or order?

Automatic exercise threshold for equity options is the reason.

Today, I received the following message from two of my brokerage firms that reminded me of that day.

“Beginning October 2006, the Options Clearing Corporation (OCC) will implement a change to reduce the automatic exercise threshold for equity options. The current threshold of $0.25 will be set at $0.05 for expiring options that are automatically exercised by the OCC. The threshold for index options will remain at $0.01.”

Who cares about a measly $0.20? You can’t even buy a stick of gum with that.

For options traders this could mean a huge potential loss, margin calls and a whole lot of trouble.

Let’s go over a few simple reminders about options trading. Options are contracts that allow a person to buy or sell securities, for example stocks, at a predetermined price called option exercise price and on/or before a predetermined date in the future called option expiration date.

Options represent a reserved right but not an obligation. In other words, the holder of this right, that is to say the buyer, can exercise this right or not.

For example if you own a Microsoft January 25 Call Option, it gives you the right to buy Microsoft for $25.00 on or before third Friday in January. It is obvious that you would not exercise your option if Microsoft is at $20.00. In that case, if you really like Microsoft, you just go to open market and buy it for $20.00.

However, if Microsoft soars to $40, then you want to exercise your right (option) and buy the stock at $25 and turn around and sell it at $40 or keep it for further potential increase.

To exercise your options you need enough money to pay for buying the stock. Each option contract represents 100 shares of stocks, so 10 contracts represent 1000 shares of stocks. In our Microsoft example, for you to exercise 10 options contracts at the price of $25.00 requires $25,000 to be in your account.

If you don’t have that money, well, you may face margin calls and some other not so pleasant consequence. This is where the new change can cause some serious damage.

Options are a right and not an obligation except that you have to deal with automatic exercise threshold. This is the threshold the Options Clearing Corporation (OCC) uses to determine if they should exercise your right on your behalf.

In the letter I received from my brokerage firm, they informed me that if the price of the stock is only a nickel ($.05) above the exercise price, that would mean they will automatically buy the stock for me according to this new rule.

So what can options traders do not to deal with unwanted stocks?

First, they can and should watch the stock price and be proactive in the process especially on the option expiration date. Option trading is not by any stretch of imagination a passive approach. They can also call their brokerage firm and find out what other alternatives are available to them.

Seasoned options traders know what they should do and the aim of this article is to bring some facts to the attention of those who are just getting started.

In investing and in life I remember what Robert Grant said, “Men and women everywhere must exercise deliberate selection to live wisely.”

* DISCLAIMER: Vishy Dadsetan, http:/www.MyPersonalFinance.com or My Favorite Shop, Inc. do not endorse any product or company. This article does not provide investment, legal, insurance, or other professional services. If investment or other expert assistance is required, the services of a competent professional should be sought. Although Vishy Dadsetan has made every effort to ensure the accuracy and completeness of the information contained in this site, it assumes no responsibility for errors, omissions, inaccuracies, or inconsistencies.

© Vishy Dadsetan



By: Vishy Dadsetan

About the Author:

One strategy companies have used in recent years is to reward employees with options to purchase a certain amount of the company’s stock for a fixed price after a defined period of time. The employee is not required to exercise the option. Usually (and hopefully), by the time the employee’s options vest (become eligible for exercising), the market price of the stock has gone up, and they get to buy the stock for a lower price than what it’s going for in the current market.

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.



By: Tom Wheelwright

About the Author:

An Option Agreement is an agreement between two parties that provides one of the parties with the right, but not the obligation to buy, sell or obtain a specific asset at an agreed upon price at some time in the future. One common type of option agreement is a written outline that provides the details of an employee’s ability to obtain stock options. Several key aspects must be addressed in any Stock Option Agreement. For one, the exercise price should be listed. Second, the expiration date of the options must be provided. The vesting schedule should be provided. The agreement should also provide that the options are not transferable.

The most important part of an Option Agreement is that the optionee is not committed to purchasing the shares at a certain price or at a certain time. As the word suggests, the optionee has the choice to buy or not to buy. As long as the optionee provides the company with adequate consideration, this option contract is perfectly valid and enforceable. Generally, the consideration provided by the optionee is the optionee’s services to the company by way of his or her employment.

The drafters of a Stock Option Agreement must be sure that the transaction comports with all applicable laws promulgated by the Securities Exchange Commission (SEC), most importantly the reporting and liability provisions of Section 16 of the Securities Exchange Act of 1934. These rules prohibit an optionee from selling, transferring, or otherwise disposing of any of the common stock underlying the exercised options during the six (6) months immediately following the grant of the option. In fact, the agreement itself may place even stricter limitations on transfer of the stock in an effort to curtail the risk of insider trading. Also, the employee must acknowledge that his or her decision to execute the Agreement was not based on any oral or written representation as to fact or otherwise made by or on behalf of company, and was only based solely upon a review of publicly available information.

The company’s purpose in granting stock options to an executive is to motivate the executive to work hard towards the company’s growth. This purpose is undermined if the executive optionee is allowed to sell his stock immediately after exercising the option. Thus, it is reasonable to include a holding period whereby the stock cannot be sold, transferred, or otherwise disposed of.

A valid Stock Option Agreement must adequately address these legal issues and further cover in detail the representations and warranties made by each party. If the necessary language is included, a stock option agreement is valid and enforceable once executed by both parties.



By: Mark Warner

About the Author: