Some companies offer their employees the option to purchase stocks after a vesting period. There are many in the investing community who will encourage you to take action on your employee stock options as soon as possible. Other investors might tell you not to exercise them until they're near their expiration dates.
But which is the right choice? It would be best to consider your circumstances, comfort level with risk, tax situation, and a few other factors. Learn five that can affect whether you exercise your options or let them be.
- Your financial situation and needs should dictate when you exercise your stock options.
- Understand the market conditions, and forecast your taxes before you exercise your options.
- It helps to establish your risk tolerance and work out the opportunity costs of exercising your stock options.
Your Financial Needs
If you're holding your employee stock options in the hopes that the stock price will climb higher, consider your current cash needs, compared to the potential for future gains. If you need cash now, and your options have value, exercising is an excellent choice. You might not see higher stock prices in the future, and you could put the cash you can get from exercising your options to good use.
You might want to exercise if:
- You have a high-interest rate debt that you could pay off.
- You do not have adequate cash savings, and you need a larger rainy day fund or emergency fund.
- You need funds for a down payment on a house.
- You have another compelling investment opportunity that you think has more potential than the company stock.
- You need tuition funds for a child in college.
- A fairly significant amount of your financial wealth—more than 10%—is already tied up in company stock.
- Cash in hand today could provide a significant improvement to your financial situation based on your financial needs.
- You don't think the prospects for the company stock look attractive.
To turn your stock options into cash you can access, you can exercise the option and purchase the stocks. Selling the stocks and pocketing the money after taxes is one of the quickest options. You can then use the profits to reinvest in a more diverse portfolio, make the payment on your house, or cover any other significant expenses.
The Risk/Return Tradeoff
There's a component to your employee stock options called "time value." When there are many years left until the expiration date, the time value is the potential for additional future gains or losses.
Time value could be linked to lost opportunity cost. If you exercised the option, what opportunities would you lose? You might reinvest the money, but would the company stock have better returns in the future?
Opportunity cost is the loss of potential gains from one course of action when another is decided upon.
The down payment on the house might help you save money on mortgage interest, but if you purchase and hold the stocks, you might generate enough returns to finance your retirement fully.
Tax planning involves projecting your expected income and deductions over the upcoming years. Exercising all of your options in one year might bump you into a higher tax bracket.
There may be benefits for exercising some options now and waiting to exercise others. It might make good tax sense to exercise a portion of your options annually rather than wait until the expiration date to exercise them all.
Consider the volatility of your company's stock and the volatility of market conditions as a whole. The sun doesn’t always shine on a company, regardless of how well it manages its cash and innovates. Recessions can be ruthless on a company's operations and stock prices.
Speculative market bubbles are increasing in frequency. Over the last 30 years, there have been two that have caused recessions. In the 90 years between 1900 and 1990, there was only one that caused a recession—the crash of 1929 that led to the Great Depression.
If your company is experiencing significant, rapid growth in an industry, you may want to consider exercising and reinvesting in less risky investments—especially if you begin wondering if a bubble is about to burst. On the other hand, if the company has weathered recessions before, you might consider waiting.
Quantity of Options/Investor Sophistication
If yours is a financially sophisticated, high-net-worth household, you might pursue more advanced strategies than a family with less financial acumen. One good rule to follow is that if you don't understand it, don't do it.
John Olagues, the author of Getting Started In Employee Stock Options, discusses advanced employee stock option exercise strategies. John is a former stock options market maker from the Chicago Board Options Exchange and the Pacific Options Exchange in San Francisco.
According to Olagues, you can reduce risk and increase potential returns by using advanced strategies that involve selling calls and buying puts on the company stock. John is adamant that advanced option strategies are a more efficient way to reduce risk and capture the time value remaining in your options when compared to an exercise-and-sell strategy.
Olagues outlines his thoughts in 5 Golden Rules for Managing Employee Stock Options. However, advanced strategies, such as derivatives trading on company stocks, are best implemented by employees with stock options that are potentially worth $500,000 or more who are experienced investors.
When considering your employer stock options, don't blindly follow a rule of thumb or investor advice or hold all options until the last possible moment. Consider all of the factors to make a decision that fits your needs.