You got to know when to hold ‘em, know when to fold ‘em
Know when to walk away and know when to run.
(Sung in my best Kenny Rogers voice.)
Since I decided to keep a personal finance blog, my friends have determined that I am money-omnipotent. Little do they know, that I’m learning as I go along (note disclaimer at the bottom of the site) and every question encourages me to learn more, so I’m happy to research topics and share what I find. Thanks to my HomeGirl in ATL for this post…
Here’s the scenario:
- HomeGirl (HG) received company stock as part of her promotion last year. The corporation gave HG 100 shares and placed them in an account in her name administered by a third party brokerage firm (think Fidelity or Ameriprise). The stock cost the company $10 per share. This is also HG’s exercise price or grant price; the price per share she will pay to purchase the stock, regardless of the current share price or fair market value (FMV) at the time of purchase.
The catch is that she doesn’t yet own the shares; she has the option to buy them by a specified date but there’s no obligation. Now this could go one of two ways – if the share price rises above the grant price, she wins. If the share price falls below the grant price, she loses nothing because she never bought them. As with all stocks, stock options are risky and should be carefully considered when viewing them as part of your financial resources and goals.
- The option to exercise expires early next year. To exercise means to take the option granted; the options in this case are to buy the stock from the company at the price of $10 per share. If HG fails to exercise the options within the specified time, the options have no value.
- The current share price is at an all-time high, $40, so buying at the grant price is very attractive. If she were to exercise all 100 stock options today at $10 per share, her gross profit would be $30 per share, or $3,000. Of course she may have to pay brokerage fees and she’ll definitely have to pay taxes, but I’ll get to that.
- In exercising her options, she has, well, three options:
- Exercise and hold. Basically, she buys the shares at $10 each, and then holds them in the brokerage account. HG won’t get any cash back, but she now owns an investment portfolio worth $4,000 (still assuming the FMV is $40 per share).
Let’s say in two years the price rises to $50 per share. If she were to sell in two years, her profit will be the FMV ($50) less the grant price ($10) and she’ll have to pay capital gains tax on the profit ($40 x 100 shares). If the price falls, her portfolio loses money, and she does nothing but cry…and then determine when to sell before the price drops below the grant price so she won’t lose everything.
Note: the taxes you pay depends on when you sell. If you sell your stock options within one year after the stock options were exercised and within two years after the grant date, you pay ordinary income taxes, rather than capital gains, on the option transaction (the difference between the sale price at the time exercised and the grant price). For most people, ordinary income tax rates are higher than the capital gains tax rate.
This option is best if you have faith that the company’s share price will continue to rise. You can just hold the shares until you’re ready to sell, preferably after one year to minimize taxes.
- Exercise and sell-to-cover. With this option, HG buys the shares for the grant price, and sells enough shares to pay the associated taxes and fees. The remainder stays in the form of shares. So let’s say the total cost to sell (taxes and fees) is $2,000. HG would sell 50 shares at the FMV of $40 per share to cover the taxes and fees and have 50 shares in her portfolio worth $2,000.
This option is best if you think the stock price will moderately appreciate and you want to hold on to some shares as part of your investment strategy. It’s also beneficial if you exercise within two years of the grant date and want to pay the (higher) option transaction taxes out of proceeds. However, you will have to capital gains taxes on the sale of the remaining shares if they rise in value.
- Exercise and sell. HG can buy the shares for ten bucks each, then sell the shares for $40 each, pay the taxes and fees out of sale proceeds (still $20 a share), and keep the remainder of the money, about $2,000.
This option is best if you don’t think there is much room for the company’s stock to grow and you want to cash out and use the money for a good and responsible reason. To all my HGs, a Louis Vuitton Alma PM handbag is not a good or responsible reason. Say it with me, not a good or responsible reason.
So what did HomeGirl do? Nothing. The stock price has been rising steadily and she doesn’t need the money today. She has some time to decide.
That concludes Part I. I know, smart reader of mine, you’re probably wondering how do you know if a stock is going to rise, fall or stay the same and therefore, how do you know which option to take? Stay tuned for Knowing When to Hold or Fold, Part II, coming soon to an inbox near you.