Underwater stock options have an exercise price which is greater than the market price of the underlying stock. For example, you may have options with an exercise price of $10 a share while the stock is trading at $8 a share.

For obvious reasons, you do not want to exercise underwater stock options, as you would being paying more for the shares than their current market price, and the exercise itself would not generate any tax loss that you could apply against other income.

Only in extremely rare situations might you purchase stock at a price that is greater than its fair market value.

Example: Your company is privately held, so you can't buy its stock in the open market, but you believe the purchase/exercise price will turn out to be much lower than the stock price will eventually be if the company is acquired or goes public. That is a big risk.

See a related FAQ on the various approaches companies take to the problem of underwater stock options.