Stock Options: Know When To Hold 'Em

If the stock options you've received from your employer are burning a hole in your pocket, it may be time to get a second (or third) opinion before you cash in. Employees often believe they have the inside scoop on when the stock's market price will top out, and that false sense of confidence can lead you to exercise too soon and regret it later.

Employees with true inside information (specific knowledge about the company that will impact the market price when made public) cannot sell company stock based on that inside information. You don't want to end up in Sing-Sing, so be careful if you're privy to important information.

That said, a financial advisor can provide needed guidance about your stock options. The first step is to set goals: What role do the stock options have in your overall financial plan? Paying off your mortgage, funding a child's education and retirement may be uses for stock options, depending on the rest of your portfolio and the amount of time left to exercise the options.

Become educated about your stock options: the terms of their exercise, tax issues and gain-loss consequences. The two types of options (nonqualified and incentive) have very different tax treatment that could consume a large portion of any profit you gain when you exercise the option and then sell the stock. You should consult a tax advisor about implications of exercising options, based on your specific tax bracket and information.

The value of your stock options lies in more than just the difference between exercise price and market price. The time remaining before the options expire (also referred to as time value or leverage), your concentration in your employer's stock and tax impact all factor into determining the true value of your stock options.

Stocks, historically, increase in value over time—although there is never a guarantee on that. By waiting to exercise, you may enjoy all the upside potential without any cash investment, and that difference between the exercise price and the market price grows untaxed. Conversely, if the stock price declines while you continue to hold the stock options, their potential value may be reduced to zero.

The exception to the "hold 'em" rule lies in that stock concentration issue. Your salary already depends on your employer. Having too much of your future also tied to your employer can result in a double whammy if the company runs into trouble—loss of income and loss of potential gains from your stock options. As a rule of thumb, if stock options account for more than 25 percent of your net worth, you may want to consider exercising, selling and diversifying your portfolio. This risk management tactic can provide more value than the additional gains you would see if you held the options for the full period.

The other caveat on holding stock options lies in that important tax issue. Waiting until the last minute to exercise incentive options reduces your control over when gains are taxed.

Don't confuse widespread with simple. Although a growing number of companies now use stock options as part of their compensation or incentive packages, they remain a complex investment device. You should consult with a financial advisor and a tax professional on how to plan the exercise of your stock options.