Exercising stock options

In Lesson 10

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Top things to know Employee stock options ESO ABCs Types of options Exercising stock options

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There are three basic ways to exercise options: pay cash, swap company stock you already own, or engage in a "cashless exercise."

This is the most straightforward route. You give your employer the necessary money and get stock certificates in return. What if, when it comes time to exercise, you don't have enough cash on hand to buy the option shares and pay any resulting tax?

Some employers let you trade company stock you already own to acquire option stock. Say your company stock sells for $50 a share, and you have an ISO to buy 5,000 additional shares for $25 each.

Instead of paying $125,000 in cash to exercise the option, you could exchange 2,500 shares (with a total market value of $125,000) you already own for the 5,000 new shares. This strategy has the additional benefit of limiting your concentration in company stock (see below). Note: You must have held the swapped ISO shares for the required one- and two-year holding periods to avoid having the exchange treated as a sale and thus incurring tax.

This is a case in which you borrow from a stockbroker the money needed to exercise your option and, simultaneously, sell at least enough shares to cover your costs, including taxes and broker's commissions. Any balance is paid to you in cash or stock.

Although conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and therefore maximize your gain, many employees can't stand to wait that long. One pre-bear-market study found that the typical employee cashed out of options within six months of becoming eligible to do so, thereby sacrificing an estimated $1 in future value for every $2 realized.

There are many legitimate reasons to exercise early. Among them:

1. You have lost faith in your employer's prospects and therefore in its stock.

2. You are overdosing on company shares. (It is generally imprudent to keep more than 10 percent of your portfolio in employer stock.)

3. You want to avoid getting pushed into a higher tax bracket. Waiting to exercise all your options at once could do just that. Exercising a portion at a time can alleviate the problem.

During the tech stock bubble, for example, at least a few conservative employees took profits in their high-flying companies' shares. Turning paper gains in options into real cash - despite exercising "early" according to conventional wisdom - seems to have been extraordinarily prudent in retrospect.

A quick way to estimate the value of your options is to calculate how much you would pocket after exercising them and immediately selling the shares. (Remember also that income tax will be due on that gain.)

You may be tempted to lock in a low-cost basis for your nonqualified options. Since the spread at exercise is taxed as ordinary income, it might make sense to exercise early so you can take most of your earnings in stock appreciation, taxed at lower, capital gains rates. This assumes, however, that you expect the price of the stock to continue rising in the future.

It's vital to remember that when you hold onto shares that have been converted from exercised options, it is the same as making an investment in the stock. Any time you hold stock - regardless of the method by which you acquire that equity - it carries the same potential risk. If you're not comfortable with the possibility of a decline, don't hold onto the shares. 

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