Tory G. from Memphis, TN asks: Good morning, Mitch. I’m writing today to ask about exercising stock options. I’m an employee at FedEx and have been trying to weigh the pros and cons of exercising my non-qualified stock options this year, and wonder if you have some tips to consider. Thank you!
Mitch’s Response:
Thanks for writing, Tory, and congratulations on your stock options. Employers generally offer stock options as a form of compensation and/or reward for time dedicated to the company, so I’m sure you worked hard to be in this position.
Exercising stock options, as I’m sure you’re aware, is a rather complex undertaking with many considerations and pros and cons to weigh. Without knowing your financial situation or the details of your grant offer, I am unable to offer you specific advice on your stock options. But I can share some high-level thoughts that may help you make a more informed decision.1
First relates to the strike price of your options relative to the current market price of the stock. If the stock’s market price at the time of exercising your options is higher than the strike price, the options are “in the money” and you’d be obtaining shares likely at an attractive price. However, if the market price is below the strike price, the options are considered “out of the money” or “underwater.” In that case, you may not want to exercise the options at this moment, as you’d pay more to exercise them than you would to simply buy shares on the open market.
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The second is a quick note about tax treatment. Non-qualified stock options, or NQSOs, are taxed as ordinary income regardless of the holding period—i.e., you will likely owe ordinary income tax on the difference (or the spread) between the market price at the time of exercise and the strike price. NQSOs are also typically subject to income and payroll tax withholding at the time of exercise, so you’ll just want to be aware of your potential tax liability should you decide to move forward.
Generally speaking, stock options are an attractive asset to have – they give you the ability to own stock often at a discounted price to the market. However, as with any investment, there are also risks worth weighing—and perhaps the top among them is concentration risk.
Amassing a significant stake in a company via options and/or shares increases the portion of your total net worth attached to a single company—i.e., your total net worth may be heavily concentrated in a single company. However great the company may be—however profitable, fast-growing, etc.—things can always go wrong, and possibly quickly.
Your best defense against concentration risk is to build a sufficiently diversified portfolio of assets. That may mean exercising options to reduce your overall weight in a single company, and/or pursuing investments in other non-correlated assets and strategies to create some balance. When considering the benefits and risks of stock options, an investor should first survey their entire net worth and evaluate the level of single security concentration in your portfolio. The goal, ultimately, is to appropriately diversify a portfolio in an effort not only to control risk but also to expand your opportunity set.
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