Saturday, January 1, 2011

Selling Equity Stock vs. Options

I have a very fortunate problem.  For the first time I work for a company that gives me equity stock and options and I had no idea how to manage them.

Just recently I wanted to sell some of it to help buy a house but I ended up making the wrong decision on which was best to sell.   I imagine I'm not the only one in such a situation so I wanted to share something I learned.


The short answer is, Options are more volatile, their value to you will go up or down more than the stock will

I was basically told by a friend to always sell stock first because options only get more valuable ( assuming the stock went up in the several years before your options expired).  This didn't really make sense though, I didn't see how a share of stock was different than an option. If the price goes up $1, I get $1 more regardless of if I sell an actual share of stock or if I exercise the option.    (I'm going to assume anyone reading this is a regular employee and will do a 'sell to cover' exercise so that you just get the money right away ) 

The idea that $1 is $1 in this situation probably seems true because we're focusing more on the past growth of the stock or the current value compared to the future prospects.

So here's the simplest example I had to think of before any of this made sense.

Imagine your stock is trading at $200, and you have options with a strike price of $100 and some stock grant too.

If you need to come up with $200 by selling your equity, you have two options: Sell 1 share of stock or exercise and sell two options.   You either lose 1 share of stock or 2 options.

Now imagine the stock goes up $1.  If you sold the share of stock you just earned $2, if you sold the options you only earned $1.

It works the other way too, if it went down $1 you lost $1 from stock or $2 from option.

So options are simply more volatile, and which you sell depends on where you think your stock's price will be when you want to sell whatever you keep in the future.  If everything is going up and to the right in your view then sell the stock, if you think the economy and your stock is going to go down for several years then get rid of the options first.

Alternatively just hedge your bets

If you have no idea where your company is going you can always hedge and sell some of both so that you're balanced between the two going forward.  In this case you'd sell whatever combination such that you were left with the same number of shares of stock and options.  Your options would be worth less than the stock, but their earning power would be the same.


Or just diversify and sell it all


There's a strategy with equity that you should just sell everything and put it in a different investment because you're too invested in your company.   Your equity, salary, 401k and even your job are all based on your employer's success.  If things start to go bad for them, it's likely all of those thing will suffer.  So pull out as much as you can to diversify.

There are nasty details

you have to deal with regardless of what you sell when.  The main one of these if you have a high salary is the Alternative Minimum Tax which I'll leave you to research.  The other one is the simple tax rate.  If you just want to get cash from your Options you'll end up paying your normal tax rate on them.  However with Stock if you manage to wait a year from when it vests you could pay much less as it'll be considered Long Term Capitol Gains.

4 comments:

  1. The tax implications of selling a share versus an option are different, I think, even without the AMT. If I recall what my accountant told me correctly, then selling an option (without first buying and holding it) is taxed as regular income; selling a share is taxed either as short-term capital gain if you've held it for less than a year (in which case it's taxed as income AFAICT) or long-term capital gain if held for more than a year; long-term capital gain tax is AFAICT guaranteed to be lower than your income tax rate.

    That all assumes the share costs more when you sell it than on the day it became yours...

    ReplyDelete
  2. Interesting. It might be harder to analyze because you probably have different numbers of options and different numbers of stock units, at different starting prices.

    ReplyDelete
  3. @drake I think the last paragraph should have covered that.

    @ADSP I think the share cost should be irrelevant as the incremental future value is only based on the number of shares. If you needed money you'd have to pick specific ones to sell of course.

    ReplyDelete