Exercising stock options

Although conventional wisdom holds that you should sit on your options until they're about to expire to allow the stock to appreciate and maximize your gain, many employees can't stand to wait that long.

There are many legitimate reasons to exercise early. Among them:

1. You have lost faith in your employer's prospects and therefore in its stock.

2. You are overdosing on company shares. (It is generally imprudent to keep more than 10% of your portfolio in employer stock.)

3. You want to avoid getting pushed into a higher tax bracket. Waiting to exercise all your options at once could do just that. Exercising a portion at a time can alleviate the problem.

A quick way to estimate the value of your options is to calculate how much you would pocket after exercising them and immediately selling the shares. (Remember also that income tax will be due on that gain.)

It's vital to remember that when you hold onto shares that have been converted from exercised options, it is the same as making an investment in the stock. If you're not comfortable with the possibility of a decline, don't hold onto the shares.

There are three basic ways to exercise options:

Cash exercise

This is the most straightforward route. You give your employer the necessary money and get stock certificates in return. What if, when it comes time to exercise, you don't have enough cash on hand to buy the option shares and pay any resulting tax?

Stock swaps

Some employers let you trade company stock you already own to acquire option stock. This strategy has the additional benefit of limiting your concentration in company stock. Note: You must have held the swapped ISO shares for the required one- and two-year holding periods to avoid having the exchange treated as a sale and thus incurring tax.

Cashless exercises

This is a case in which you borrow from a stockbroker the money needed to exercise your option and, simultaneously, sell at least enough shares to cover your costs, including taxes and broker's commissions. Any balance is paid to you in cash or stock.

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