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Business Matters Making the most stock options

February 16, 2011

By Staff Reporter

By Kevin FitzGerald

We immigrated to the U.S. a little over 10 years ago and my husband took a job with a local communications company. Over the years, he has been promoted and when the company went public in 1996, he was awarded some stock options, which are now available for sale. Could you give us some information on how best to proceed?

G.S., Mineola

Since the 1950s, many companies have awarded stock options to select top executives as part of their compensation packages. Today, more and more companies are issuing stock options to reward employees for a job well done and to encourage them to become more involved in their company’s performance through direct ownership of company stock. As a result, stock options are currently the fastest-growing segment of executive compensation. In fact, some major corporations are now awarding stock options to every full-time employee, from the chief executive officer down to the newest trainee.

With stock options becoming such an important part of compensation, it’s surprising that many people don’t include their stock options as part of their overall financial plans. The fact is that the decisions you make regarding your stock options — when and how to exercise them and what to do with the stock you receive — are decisions that could have a major impact on your financial well-being.

Options and your portfolio

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Stock options grant the holder the right to buy a company’s stock at a specific price — usually the market price at the date of grant — at some point in the future. For example, you may receive an option to buy up to 500 shares of your company’s stock for $50 per share any time between now and March 1999. If the stock increases to more than $50 per share, you can exercise your options and then resell the shares on the open market, cashing in on the difference in price.

Before deciding whether, or when, to exercise your options, it’s important for you to view them as part of your overall financial plan. But how do you value an option that hasn’t been exercised? The value of stock options is usually considered to be the option spread: the difference between the price the option may be exercised at (the strike price), and the market value of the actual stock. So, if you own 750 options of your company’s stock at a strike price of $60 and the market price of the stock is $100, the option spread is $40 per share, or $30,000.

Now that you’ve determined the worth of your option spread, you can see what weight it has in your overall portfolio. Let’s assume that you have $5,000 in cash or cash equivalents, $30,000 in fixed income investments, another $35,000 in other stocks, and your option spread of $30,000. In this case, your option spread is worth 30 percent of your total portfolio and more than 46 percent of your equity portfolio.

Is that too high a percentage? Only you know how much of your company’s stock you’re comfortable owning. But if you’re concerned with diversifying your portfolio, you should keep in mind that most professional investment managers limit the ownership of one specific stock to no more than 5 percent of the total worth of the portfolio.

Another thing to consider is the effect of your stock options on the volatility level of your portfolio. Using the same example as before, let’s see how a change in the market price of your stock will affect your option spread. If the market price goes from $100 to $110, the value of your option spread will climb from $30,000 to $37,000. Conversely, if the stock drops to $90 per share, your spread will be worth only $22,500. In other words, with a 10 percent increase or decrease in the market price of the stock, your spread will increase or decrease 25 percent accordingly. That’s 2.5 times as volatile as the stock itself.

When to exercise your options

In addition to the diversification and volatility issues, there are many other variables to consider when determining the best time to exercise your options. Obviously, your investment objectives should play a major role in making that decision. Do you have a large financial responsibility looming, such as financing a child’s education or meeting a balloon payment on your mortgage? Are you nearing retirement? How do your stock options figure into your estate planning? To explore these and other considerations, you should consult with your professional investment executive.

Another issue to consider is taxes. Although you are not required to pay taxes on options at the time they are granted to you, once you exercise those options, the tax implications can get complicated. There are a variety of factors that will affect your tax liability on option exercise, such as the type of option you own, the length of time you’ve held the option, and whether or not your proceeds will be subject to the alternative minimum tax. You should consult with your tax advisor to discuss your own situation.

Exercising your options

Assuming you’ve decided to exercise your stock options, you still have some choices to make. How will you fiancee the transaction? And what will you do with the shares your receive?

Many companies and securities firms have teamed up to make it easier for people to exercise their stock options through “cash-less” exercise programs. Here’s how it works: the company agrees to deliver your stock to your brokerage account after the exercise payment (plus withholding taxes, if any) is paid. Your broker uses this guaranteed delivery as collateral for your loan and will forward the exercise payment to the company on your behalf. Some or all of the resulting shares are immediately sold. The initial proceeds of the sale pay transaction fees and taxes, and the remainder are distributed to the employee. Check with your company or your investment executive to see if you can take advantage of such a stock option financing program.

You should also note that the Securities and Exchange Commission’s Insider Trading Rules make it easier for top executives to exercise their options than in the past. Formerly, there was a mandatory 6-month waiting period from the time Insiders exercised their options to the time they could sell the shares they received, leaving them open to the risk that their shares could decline in price on the open market during that time. Under current rules, there’s still a 6-month waiting period, but the clock starts ticking from the time the options are granted, helping to eliminate some of that market risk.

Once you have exercised your options, you’ll want to decide what to do with the shares you’ve received. For example: Should you sell all or a portion of the shares? Should you reinvest your proceeds in other stocks or fixed income investments? Should you use the proceeds to meet an upcoming financial responsibility?

Again, it’s important to make these decisions in concert with your overall financial plan. Talk to your investment executive to decide what “options” are best for you.

The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Kevin FitzGerald is first vice president-investments at Paine Webber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 654-6162, ext. 448.

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