By Andy Mardock, CFP®
With the recent wild ride in stocks, we have been asked quite a bit lately: “My company stock is down 20%. What should I do with my out-of-the-money stock options?”
First, let’s define “out-of-the-money.” A stock option is simply the right to buy a company’s stock at a certain price, called the “strike price.” If the stock is trading above the strike price, the option is considered in-the-money. The difference between the strike price – which you would pay to exercise – and the market value is your gain. If the stock is trading below the strike price, it is considered “out-of-the-money.”
An out-of-the-money stock option must be worthless, right? At present, yes, but it might not stay that way. Stock prices are constantly moving, and an out-of-the-money option will become in-the-money if the company’s stock price increases above the strike price. What’s the takeaway? Know the strike price of your vested stock options. Set an alert to notify you when the stock reaches a certain price. The custodian holding your stock plan may have this feature available via your login. You can also download a stock alert app to your phone that will send a notification when your company stock reaches a specified price. Out of sight, out of mind is not a good approach for managing your stock options.
A logical question to ask would be, “Should I ever exercise out-of-the-money stock options?” In the vast majority of cases, the answer is no. However, a sample instance in which one might exercise underwater stock options is for early employees of the company. Startups often use inexpensive stock options – 50 cents per share, for example – to compensate talented employees when cash flows are tight early on. Prior to an IPO, there may be no buyer for the illiquid stock. As a result, the stock has no marketable value – yet. An employee with 1,000 stock options could exercise the shares for $500 in hopes of a favorable IPO price. Until there is a liquid market, however, this is a speculative investment. The company could go out of business before it is able to IPO, and the exercised stock shares would be worth nothing (doubly painful for the employee). The employee in this scenario should not allocate any money to exercising options she or he cannot accept losing.
While the idea of waiting for the stock price to recover is no fun for anyone, recognize that your stock options cost nothing to hold and there is no tax for waiting. Unexercised stock options haven’t required you to invest even a nickel, and the right to buy shares at a lower price if the stock recovers is only positive for you. Don’t lose hope, and understand your stock option grants to know what you have the right to buy.