"In a bull market, sometimes investors get too greedy and hold on to their options because they think the stock is going to keep going up," said Mark Maes, a senior financial adviser with Ameriprise in Edina. "Then, when it drops, they still don't want to sell because they think the price will go back up. That happened at ADC Telecommunications a few years ago. The stock dropped and didn't go back up and the stock options expired worthless. That cost some people millions of dollars. The same thing happened at many other high-tech companies when the tech market crashed."
Maes, who helps employees at Cargill, Best Buy Co. Inc., 3M Co., UnitedHealth Group Inc., Ameriprise and other Twin Cities companies manage employee stock options, said option-holders need a plan and a strategy for exercising options just as they would for other investments. "I try to help them lay out a schedule for exercising their options. We look at their investment goals for the short term and the long term, as well as their retirement goals and other factors, such as their risk threshold."
Hundreds of companies offer stock options to their employees as part of an employee compensation package that is intended to encourage them to stay with the company and work hard to help drive the growth of the company.
Typically, when stock options are issued, they have an "exercise" price or "strike" price that is about the same as the current stock price. They also have a time frame during which the holders must exercise or cash in those options.
For instance a company with a stock trading at $30 might give an employee options on 1,000 shares with a strike price of $30 and an exercise period of 10 years. If the stock never exceeds $30 during that 10-year period, the options expire worthless. Or, in the case of ADC, shares went up well beyond the strike price, then dropped back down below the strike price. For those who hadn't exercised their options when they were "in the money," their options ultimately expired worthless.
When options exceed their strike price, the holder can earn the difference between the stock price and the strike price. For example, if you hold options on 1,000 shares of Best Buy stock with a strike price of $30 and the stock goes to $40, the value of your options would be the difference between $30 and $40 -- $10 a share for a total value of $10,000 for 1,000 shares.
The dilemma for options holders is deciding when to exercise shares. Would you cash them in with a $10 gain or should you wait and see if the stock continues to climb? If the stock of Best Buy were to go from $40 to $50, you would double your options value, from $10,000 to $20,000. But if it drops to $30, you lose all their value.
The other factor is timing. Generally you would have about a 10-year window to exercise options (likely after a vesting period of three or four years), after which they expire worthless.
Maes says the greatest difficulty for most options holders is deciding exactly when to exercise them -- not too soon, if the stock seems to be moving up, and not too late after the price peaks and seems to be dropping back down. But there are some factors to look at to decide the best time to start cashing in.
"That's what I help people do -- lay out a time line and a discipline," Maes said. "I recommend exercising your options in phases rather than all at once."
What do you look for in deciding whether to exercise options? Maes suggests looking at the fundamentals of the stock, the value of the leveraging of the option and the time frame before the options expire.
The leveraging is key. Once the stock passes the strike price, the higher it goes, the lower the leverage and the less point there is in holding on.
For instance, say the strike price is $30 and the stock is at $35; if it goes up $5 more, that represents a 100 percent gain in your option value (from $5 to $10). At that level, it's worth holding on to your options if you have plenty of time before they expire. But if the stock is at $130, with the same $30 strike price, a $5 gain to $135 would move the value of your options from $100 to $105 -- only a 5 percent gain. There would be little point in holding the options beyond that level.
"The greater the difference between the strike price and the current stock price, the less reason you have to hold on to your options. More of your own money -- your captured gains -- is at stake, so you have more to lose and less to gain. At that point, it's time to cash in your options, pay the taxes and diversify into some other stocks."