Stock options are one of several investment choices. Once you have chosen to participate in a stock option, you have limited time to take advantage of the agreed-upon rate.
But should you hold your option for as long as possible? Or should you exercise? In order to make the best choice for your personal financial goals, you need to understand how options work and what you stand to gain – or lose – by exercising.
How Does a Stock Option Work?
A stock option is a type of contract that gives you the right to buy or sell a stock at a specific, agreed-upon price and date – but does not obligate you to do so. You buy into this contract by paying a fee. This contract will stipulate a certain rate at which you may buy or sell an asset-in this case, a stock or cluster of shares. For example, say that Company A’s stock is currently worth $400 per share. You purchase a stock option that allows you to buy company A’s stock for $400 per share any time in the next three years.
At the start, it may not feel like buying a stock option has accomplished anything. However, imagine that two years after the date that you acquired the stock option, Company A’s stock is worth $2,000 per share. Because you are participating in the option, you may still buy shares at $400 each. This constitutes a profit of $1600 per share if you choose to act-or, in financial terms, exercise.
What Exercising Your Stock Option Means
Exercising your stock option means taking advantage of the contract and the underlying terms to which you agreed. The two main types of stock option contracts are call options and put options. Call options give you the right to buy a stock for a designated price within a specified timeframe.Exercising a call option means committing to buying the shares at the price stipulated in the contract. Put options, by contrast, give you the right to sell your shares for a set price (the “strike price”) – even if the stock’s shares have since dropped below the strike price. However, there’s a limit on how long you have to exercise a put option. Your contract will state the date of the put option’s expiration. The term “exercise”, as it is used here, means to “put into effect” the agreement you made when you acquired and signed for the stock option. Keep in mind that stock options are not without limits. The ability to exercise an option doesn’t last forever – stock options operate within a time limit. If you exercise the option once the time limit has expired, you are no longer eligible to receive the stock option’s benefits. For call options, that means there is no longer a cap on the price you’ll pay for the stock. For put options, that means there is no longer a bottom limit on the price for which you can sell your shares.
When to Hold Your Stock Option
The question of managing your stock options, then, becomes a question of whether to keep holding the option or to exercise. You are faced with a time limit, but you do not want to wait forever.
In general, hold your stock option if exercising it would otherwise produce a negative rate of return. You should also hold your stock option if you think that, over time, the stock’s value will change in your favor. While it is not a typical recommendation to try to “time” the market, certain events – like the release of a new product, or a company going public – could convince you to hold your option until stock prices rise. Remember that you are not obligated to hold your stock option until its expiration date; in many cases, you may exercise anytime.
When to Exercise Your Stock Option
Exercising your stock option requires careful planning and consideration. You may find it advantageous to exercise your stock option if doing so would produce a positive return, or if you want to purchase or sell as many of the company’s shares as possible. Likewise, if you believe that a company’s growth is collapsing, you may exercise your stock option to generate as much of a return as possible before the stock price plummets. Each stock option is different, so there is no single best time to exercise that applies to all cases.
Things to Keep in Mind
Stock options can be a powerful investment tool, but there are some things that you need to keep in mind. Options will impact your tax situation. Consider exercising gradually over time instead of all at once to spread out your tax burden and avoid jumping into a higher bracket. How soon you exercise (or sell the stocks you acquired from the option) after you participate will also impact how much you pay in taxes and what sorts of taxes you pay. A professional can help you understand how this all ties together and how to make strategic choices.
Trust the Experts to Help You Calculate the Ideal Time to Exercise
If you are faced with the choice to purchase a stock option-or the decision of whether to hold or exercise-you do not need to calculate all of the pros and cons on your own. The professionals at Inflection Advisors would be happy to help. Reach out to schedule an appointment to discuss your financial goals and how to make your stock options work for you.