With the stock market reaching new highs on a regular basis, the question of what to do with stock options is weighing heavily on many individual’s minds.  While each individual’s situation is unique, there are some factors that you should consider as you make this decision:

What is your plan?  Decisions regarding the sale or retention of stock options need to be considered in the context of a comprehensive financial plan.  That plan should include a written strategy on when and how the options should be exercised.  If you do not have such a plan, you need to develop it prior to making any hasty decisions.

Why would I cash out my options?  Many individuals sell their options based on their feelings regarding the market and/or on what their peers are telling them.  These are normally NOT the best reasons to sell or retain your options.

The decision to divest your options needs to be based on rational, well defined criteria and not your emotions.  Again, a comprehensive financial plan should be in place which defines when the options are to be divested.

Are there any limitations/implications?  Successful managers often have limitations placed on them by their employers.  These limitations include targeted ownership requirements and/or certain restricted windows for transactions.  Before making any decision on your options, you need to review and understand all the limitations which are in place for your particular situation.

What’s the alternative?  Perhaps even after reading the above about the need to develop and implement a comprehensive plan, you have decided to skip this critical step (NOT recommended!) and proceed with exercising your options.  Before you do so, you should have a clear plan on what you will do with the funds.  Potential uses include investing for retirement, funding children’s education, paying off the mortgage, taking a much needed vacation as a family, etc.  All of these options – and many others as well – have the potential to satisfy one or more of you and your family’s needs.   However, should you exercise your options without a clear picture of what will happen to the proceeds, it is highly likely that you will either (i) not leverage the proceeds appropriately for your future or (ii) allow the proceed to slowly “trickle away”.  Make sure you know your alternatives prior to exercising.

What is the upside potential of the option?  Options have two components of value.  The first of these is an intrinsic value that is represented by how much the option is “in the money” – if the stock is trading at $100 and your option has a strike price of $25, the intrinsic value is $75.  The second of these is a time value.  This represents potential appreciation of the option.  I’ll spare you a discussion of Black-Scholes pricing models for options.  What you need to know is the following: (i) the longer the time remaining until the option expiration, the higher the time value and (ii) the higher the intrinsic value, the less the time value of the option.  Both insights are important and give rise to the following general guidelines:  (i) if an option has multiple years remaining until expiration, you should be cautious about exercising too early, and (ii) if an option has significant intrinsic value, you should be cautious about continuing to hold longer.  Unless you’re handy with a spreadsheet, I’d strongly recommend seeking out professional advice on the exact “break points” for the time and price of the option execution.

Do you understand the tax implications?  When you build your strategy for exercising your options, you need to take the tax implications in to account.  Multiple year tax projections are strongly recommended as you develop your strategy for exercising your options.  As our tax system is progressive, it may be advantageous to exercise certain options a bit earlier to “fill up” a lower tax bracket in an earlier year.  Further, as your options increase in value, it may be advantageous to exercise and convert to the underlying security’s shares in certain instances.   The key here is to make sure you factor taxes in to any decision you make prior to execution.

Individual situations are much too unique and diverse to provide a “one size fits all” strategy when it comes to exercising your options.  The purpose of this article was to provide you with some considerations to include in your decision making process.  By asking yourself these questions, you will start the process of answering if it makes sense to cash out your stock options.  By answering the questions, you will be able to develop part of your plan.

If you are comfortable with the topics discussed, then build your plan and move forward with its execution.  If you are not comfortable with the topics above and/or do not have the time to investigate in sufficient detail, I’d encourage you to seek out the guidance and support of a professional.

Remember plans are worthless if they are not well thought out and implemented.

[author] [author_image timthumb=’on’]https://www.f5fp.com/wp-content/uploads/2012/02/100_3458-Cloned-background-1-214×300.jpg[/author_image] [author_info]F5 Financial Planning, L.L.C. (F5FP) is a comprehensive, fee-only, financial planning firm serving Naperville and surrounding communities.

Led by Curt Stowers, F5FP focuses on providing corporate executives, entrepreneurs, and families with comprehensive financial planning that leads to financial security, simplicity, and success. As an executive with Caterpillar for 18 years, Curt brings real, practical experience to financial planning. Curt has successfully passed the examination to be awarded the CERTIFIED FINANCIAL PLANNER™ credential.[/author_info] [/author]