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When you are employed by a company that offers retirement benefits like a 401(k), if you’re like most people, you have some familiarity with the account. At the very least you probably know how to check your balance on the website. But for those of you who have access to a company stock plan account, they often contain a seemingly jumbled mix of actual stock, RSUs, vested options, dates for future options, and cryptic names like RSU21523 -01PG. Where do you begin?

I can’t make you an expert on stock plans just by reading a blog. Instead, maybe this article can give you a couple of pieces of information to take away, and at least help you to know better what questions to ask if your employer offers a stock option plan.

What is a stock option?

We’ll begin with the most basic overview we can, what is a stock option? In its simplest form, a stock option is a contractual right to obtain ownership (shares) of your company. The company gives you the right to exercise the option at a certain time, and buy shares at a certain price. Since these grants and options have a value to them both at the time they’re granted and the time they’re exercised, there is usually tax consideration to also be mindful of. These tax considerations vary depending on how these shares are given, and when you exercise the options.

Stock options, regardless of type, contain the ability to purchase a certain number of shares at a certain price within a certain time frame. Much like a 401(k) plan, stock options typically have a vesting period. This term refers to the period you must remain with the company before the option can be exercised. Leave before the vesting period is over, and you forfeit these options. It’s important to note that often a particular grant of stock options can have different vesting schedules. For example, you might receive 5000 stock options, of which only 1000 can be exercised in the first year, 1000 the year following, etc. etc.

Stock options also contain an exercise price. Just as an option contract in the stock market, the exercise price is the amount you’ll pay per share. In most cases, the exercise price is the same or close to the price of the shares in the market at the time of the grant. As the share price goes up while you hold the options contract, so does the intrinsic value of the stock option itself.

A stock option grant should not be confused with a restricted stock unit (RSU) or stock grant. These refer to actual shares of stock that are given directly by the company to the employee, and don’t allow you to decide when to exercise a contract and transfer the option into stock. But often a stock plan account statement contains RSUs (shares that haven’t vested yet), shares given directly to the employee through grant, or shares of stock already exercised through an option, but not yet sold.

How to exercise a stock option

Once you become vested in the stock option, and the value of the stock in the market exceeds the exercise price, you have the ability to exercise the contract and purchase the shares. You can simply transfer cash from an existing account to make your purchase, or in the case of many employers, purchase your options through salary deduction. A very common transaction that you should also be familiar with is the cashless exercise. In a cashless exercise, you would exercise enough shares to be purchased with the contract and immediately sold to cover the cost of the remaining shares and associated taxes. If a company issues 500 options at $10 each to exercise, the employee would have to pay $5,000 cash to make the purchase. Through a cashless exercise, let’s assume the current market price is $20/share, giving the value of the exercise a total of $10,000. Custodians of the stock plans will provide an immediate margin loan to exercise the contracts, then sell 250 shares (we’ll assume an additional 50 shares to cover taxes), and the end result is the client is left with 200 shares at a value of $4,000, without transferring any cash into the account.

One final note to remember if you have a stock plan, is that stock options typically have a limited window before expiration. This window of time is usually shorter than the vesting period, so it’s important to have a strategy in place if you’re on the fence about whether or not to exercise. If a stock option expires, it is forfeited without any compensation to the holder. In some plans, retirement or disability during an exercise period (the time between vesting and expiration) can trigger required action or changes to expiration. It’s important if you are in this situation to review the fine print to ensure nothing is forfeited in oversight.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.