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Stock Option Strategy: What’s Yours?

Stock options can represent a considerable portion of your compensation package, but a number of factors should be managed. 

Stock Options
Online exclusive

Stock Option Strategy: What’s Yours?

Stock options can represent a considerable portion of your compensation package, but a number of factors should be managed. 

For many in corporate America, stock options remain a key part of compensation plans. These instruments, which allow the recipient to purchase the company’s common stock at a set price for a finite period of time, potentially provide enhanced exposure to future gains in the company stock.

Yet risks do exist. Careful consideration is essential to tap the value that stock options may offer, says John Voltaggio, a managing director of Wealth Management at Northern Trust.

“Stock options are a great opportunity to accumulate wealth because they are a leveraged form of exposure to an employer’s stock,” says Voltaggio, who recently discussed common stock options mistakes people make with the Wall Street Journal. “When viewed in combination with a salary, bonus, benefits and other stock holdings in the company, however, the pretax exposure to that company is much greater. So an option is a risky asset, and it’s an asset you may not be able to monetize when you want to.”

Key Components Underscore Stock Option Strategy

Not all stock options are created alike, and the details drive the planning and possibilities for option holders. For a solid baseline, stock option recipients should understand the following:

  • Strike price: The price at which the option holder may purchase a share of common stock. If the actual price of the common stock is above the strike price, the option is “in the money,” or has value. If the actual price of the common stock is below the strike price, the option has none.
  • Vesting terms: An option must vest before the holder can exercise it. Generally, an option requires an employee or director to remain with the company a specific amount of time before it vests. Common variables in vesting schedules include a change in control of the company and the recipient’s retirement.
  • Expiration date: Options frequently are set to expire between five and 10 years. This may be accelerated if the option holder leaves the company or retires.
  • Grant date: The date the option is awarded provides context for vesting schedules and expiration dates. “A grantee really needs to understand the nature of an option’s grant and its provisions,” Voltaggio says. “And while that’s important for any option holder, it’s even more relevant to those in a startup situation, where a change in corporate structure is more likely and employees are not going to necessarily be there for a long time.”

Elevated Risks and Rewards Are a Possibility With Stock Options

Inherently, a stock option can be riskier than a common stock. “All that needs to happen for an option to be of zero value is for the common stock price to drop below the strike price. It doesn’t have to fall to zero,” Voltaggio says. “So an option holder has to understand the type of exposure this is, and plan his or her portfolio around that.”"All that needs to happen for an option to be of zero value is for the common stock price to drop below the strike price. It doesn't have to fall to zero." 

To mitigate some of the risk, he recommends grantees exercise their options three-fourths of the way to expiration. This helps avoid the risk that a temporary decline in the common stock price renders options valueless just before the expiration date.

Meanwhile, much of an option’s potential reward hinges on the spread, or the difference between the strike price and the common stock price. The spread could represent a significant after-tax windfall, Voltaggio says.

For example, if the spread on a non-qualified stock option equals $20 per share, and the option holder completes a cashless exercise (or swaps existing shares to pay the strike price and taxes and then sells the resulting shares), he or she could collect $12 per option after subtracting 40% for taxes. In a less-common scenario, the option holder may pay cash for the strike price and taxes, and retain the common stock shares in his or her portfolio.

Company insiders, such as officers, executives and directors, must be mindful of blackout periods, during which stock sales are prohibited, as well as minimum ownership requirements and public relations-driven policies against selling company stock. When pertinent, Voltaggio suggests setting up a 10b5-1 plan, which establishes a set schedule for selling blocks of common stock.

Stock Options Are Best When Part of a Comprehensive Plan

Stock options may be incorporated into an estate plan as well, as non-qualified stock options can be transferred to select types of trusts — if the company’s plan allows it. Voltaggio suggests carefully weighing tax implications of such a move, as the trust benefits from the full value of the option, but the original option holder is responsible for any resulting income taxes.

“It’s a very aggressive form of wealth transfer, but can be very effective,” he says. “Obviously, you need to make sure that you can afford to live without this asset for your retirement planning. But from a cash flow planning perspective, you also need to be certain that you’ll have enough assets and cash flow from elsewhere to pay the income tax liability.”

Such holistic thinking plays a role in Northern Trust’s Goals Driven Investing approach, in which clients develop a series of life goals and determine a path to get there. The broad strategy can be especially valuable for individuals who hold considerable exposure to one company and contend with varying limitations on selling stock in that company, Voltaggio says.

“We like to say that every asset has a purpose, and the purpose of stock options is to accelerate exposure to an employer’s stock, which will hopefully grow the grantee’s wealth significantly,” he says.