The Simple Dollar Takes A Brief Look At Stock Options

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A reader (whose identity shall remain secret) writes:

I had a question about stock options that I was hoping you could answer. I work for a BIG internet company (you can probably guess which one). I have 114 stock options; a quarter of which vest each year for four years with a 10 year lifespan. The stock price is currently quite high, and I was wondering if you had such options would you cash out at a high stock price or hold on to them for the 10 year period. I don’t “need” the cash for living expenses or debt, but I don’t have very much for travel and other such things.

Let’s “guess” that this person works for Google (GOOG). Google’s stock currently sits at about 508. I’m going to speculate that this person’s option exercise price is rather low, substantially lower than the current price (if it’s close to the price or equal to it, ignore what is being said here and hold it).

The biggest question you need to ask yourself is do you believe that your company is going to continue to grow at a rapid pace? You should have somewhat more insight into this than the average person because you work for the company. Are there good, money making products in the pipeline? Or does it look like there’s no significant room for very strong growth? I can’t answer this question for you, but I can tell you to trust your gut above everything else. Don’t try to talk yourself into feeling one way or another about the answer to that question, just listen to your gut and follow it.

If it looks like there’s still significant gas left in the tank for the company itself to grow, hold the options for now. You should wait until the instant your gut begins to tell you that the skyrocketing is slowing down or is over, then exercise the options and sell the stock.

The reason is that when a company begins to show signs of slowdown in growth, their stock usually takes a pretty strong hit for a while as it stops being a growth stock and moves to being an ordinary or a value stock. This means the price to earnings ratio is going to go down rapidly, and if the earnings aren’t still growing rapidly, the only place for the stock to go is down – or at the very least, many years of sitting in the doldrums with no growth at all. In the long run, if the company is good, it will grow again, but it may take a very long time to reach its earlier heights.

Also, don’t worry about not hitting it at the exact perfect moment to maximize your dollar. The truth is that no matter what you do, you won’t time it perfectly unless you’re simply incredibly lucky.

Good luck – you’re likely to make some good money no matter what you do.

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23 thoughts on “The Simple Dollar Takes A Brief Look At Stock Options

  1. I have several friends who work for Google. Two have told me that they cash out their options right when they vest (and plow it into other investments) as a form of risk diversification. After all, they are employed by the company; if the company starts to go south, the options will be worth much less, and they will be in danger of losing their jobs. It’s got nothing to do with their appraisal of the company or with the current stock price.

  2. I agree with Wanda 100%, and I am frankly shocked to read the Simple Dollar giving different advice than that.

  3. An alternative would be to go short on options for google (buy puts for GOOG) at the current stock price. What this does is to “lock” your current profit (minus the premium you will pay for the puts). If the market goes UP your calls will continue to make profit and your puts will become dust, whenever you cash out you will have all profit minus the premium for the puts. If the market goes DOWN (below the current market price) your calls will make less profit but your puts will make profit to compensate for it.

    I’m not sure if that is clear, if it’s not please let me know and I’ll rephrase.

    Nice advice by the way.

  4. @Pedro,

    Some companies ban employees from taking short positions on company stock, including buying put options. (Where I work, even as an intern this is the case).

  5. !wanda makes a good point about the lack of diversification when your employer and investments are one and the same. If you feel the stock has some potential and want to stay invested, it may make sense to exercise/sell half of your shares and keep the other half.

  6. It’s dangerous to have a big chunk of your net worth in one company. After losing a bunch of money in options that became worthless (yet some of which were vested earlier and could have been sold for hundreds of thousands of dollars of profit), my strategy is to always exercise and sell at the earliest opportunity, and reinvest with diversity. There are lots of growth funds that include Google as a component.

  7. If the company really is Google, or even if it isn’t, the emailer should also check company policy on insider trading and who constitutes an insider. Some companies have really restrictive definitions of who an insider is.

  8. It doesn’t have to be all or nothing. I would suggest selling 1/2 and let the other 1/2 ride for awhile.

  9. I like the Dave Ramsey approach to questions like this. If you had the cash value of the options would you invest it in company stock? The answer is almost always going to be no.

  10. I’m a bit concerned about the direction Trent is going lately. This is the second question in two days that he is obviously unqualified to answer but he went ahead anyway. There are many factors to consider when you’re dealing with stock options, and you do a disservice to your readers by offering advice on topics you know little about. You can’t discuss stock options without discussing the tax treatment of the options, AMT risk, and many other factors.

    Trent isn’t a financial advisor and he shouldn’t answer questions that require knowledge he doesn’t have. He didn’t even ask if the options are ISO or non-qualified. You can’t give any sort of useful answer without such basic information.

  11. @Chris: I see. I would carefully check what the company policy says about it. Afterall, if you hold a call and put position your net position is neutral, and not short ;-)

    If you still cannot buy puts, I would definately cash out and diversify, like !wanda said.

  12. Matt’s got a very good point. Now here’s my equally unqualified opinion.

    At some point the stock’s going to become overvalued, but you won’t know how overvalued it will eventually become. Because of this, I’m a huge fan of trailing stops, a great motivator for my switching to eTrade from another provider. This lets you say “When the stock drops this amount from its highest point after I place this order, sell it.” I generally choose a value of 15%–much less and it can get hit by random fluctuations, much more and it’s too big a loss to suffer.

  13. Matt: AMT is definitely a big potential concern for ISOs, and you’ll want to consider a Section 83(b) election, which can save you a ton of money… An 83(b) election also can be used for restricted stock awards (RSAs).

    The tax treatment for nonqualified options and restricted stock units (RSUs) is much simpler. RSUs seem to be the employee equity award of choice these days, now that stock options must be expensed under FASB.

  14. @ Matt, Trent often tells his readers that his advice (and that of any other PF Blog) should only be a point of discussion, not taken as gospel. With that said, there could have been a disclaimer on this particular article since it is very bare bones advice.

    @ Trent…. Ignore Matt – do your thing most of your readers understand this as a matter of course.

  15. Thanks to Chris for reminding me. Our company’s ESPP (slightly different than options, but similar in principle), will announce blackout dates for sales and prohibits “speculative positions” which includes options and short positions.

  16. I second Matt’s concern about this and the $50 million post yesterday. If you have $50 million, you can hire a tax attorney; and if you are looking at options of $50K, it’s time to talk face to face with an accountant at least. A blog is not the place for answers.

    Most tax planners will tell you that, if your company is stable, it is best to hold 10-yr options until year 6 or 7, then exercise, hold a year (so you don’t have to pay income tax rates on cap gains) then sell. So I’m pretty surprised at all the contrary advice here.

  17. Jeez you guys, lighten up a bit. :) I figure if these people are writing to Trent, they likely know enough of his story to expect that they are getting the opinion of a not-that-qualified but still thoughtful and intelligent person. If they act on his advice alone, well, that’s not very bright. But I see no harm in asking his opinion, and seeing how it meshes with other (more professional/more qualified) opinions.

    If it were me with the options, I’d talk to coworkers, read a couple of blogs/columns, read a book, and ask anyone else I knew who might be in a similar situation. Asking questions is a great starting point, better than just being paralyzed, which I’d be a large percentage of options-holders are.

  18. I’m not a big fan of Dave Ramsey, but he pretty much confines his advice to helping people get out of debt and not giving tax and investing advice. Similarly, you don’t read Ed Slott’s books to learn how to get out of debt. While it may be nice to have Trent’s common sense approach to dealing with options or trusts, it’s inadequate and potentially misleading.

  19. My father in law held and held his stock options at Xerox. He never bothered to really learn about the complexities of such an investment. His option was for $75 and now he is holding the same stock options and Xerox stock is hovering around the teens. His options are now worthless. He missed out on thousands of dollars. I don’t really know anything about this type of investment, but I do know that you must research EVERYTHING about your investments and understand them thoroughly. Consult experts, for a fee if necessary. No one would drive blindfolded, it’s scary how many people finance their futures that way.

  20. I’m with Peter R – Trent could’ve put disclaimer on such as this topic is complicated, but I don’t think any harm has come from discussion. Ideally someone who does go on to see an expert should ask questions and discuss like the writer has done here.

    As for taxes – I think too many people put the cart before the horse. Investing should be done with risk and reward first and taxes a next. Plenty of .com stock holders were left owning taxes on worthless stock because they excercised options to achieve capitals gains instead of income, and were left only with a tax bill and no money.

  21. If you already have a diversified portfolio and the options are in such a strong company like Google, then keep them. Even if it constitutes a huge portion of your net worth. Why do I say this? This is a once in a lifetime opportunity to score. You can multiply your net worth a ridiculous number of times by just sitting on options. Of course, if your assets are all riding on this one position then it would be a mistake not to diversify out of it. It’s worth keeping an almost free concentrated position in a hot stock/company if the rest of your finances are already in order.

  22. This is actually a ferociously difficult question, because the taxes on options are ferociously difficult to understand. If you get paid in stock options, your need to read the excellent book “All About Stock Options.” While many of the comments are in general correct (you want to have a diversified stock portfolio rather than own single stock), you will definitely want to know how to calculate the value of stock options before exercise and the tax consequences of selling.

  23. I think the stock options this person is talking about are not the same as put and call options. This is simply the company offering the employee to buy stocks at a price usually lower than what the market is. And if it is Google, this person is very lucky. The only way this person is able to make money is to exercise the options. These particular options only have a 10 year life span, so it is best not to wait till the 10 years is up. Also, with these options they allow you just to buy the stocks. You will probably have to sell the stocks through a broker when that time comes. That will be the year they will be tax reportable. Of course, check with your tax adviser to confirm this. Your company handbook should have more details on this. I personally would cash out 20% of the account balance each year. That would be a form of dollar cost averaging. Of course hindsight is 20/20. If you knew google was gonna go up forever or is the “walmart” of our time, then yes hold on to the options and exercise them at the last possible year. Good luck!

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