This post is the extension of the Stock Participation Plan post. Company incentive stock option was a widely used incentive in the tech. industry during the 90s and early 2000s. These options are less prevalent now because many big tech. stocks went side way in the last 10 years and many options are worthless. I’m only covering ISO (Incentive Stock Option) because that’s what I have.
So what are company stock options? It is the right to buy (“exercise”) a certain amount of company stock at a set price (“strike price.”) Let’s go through an example and pretend I work for Microsoft.
1/1/2000 – Happy new millennium! I was an awesome worker bee and MSFT decided to reward me 10,000 stock option. This is hypothetical, in real life a rank and file employee usually gets minimal options. I have received anywhere between 300 to 5,000 options during my tech. career, mostly near 300. The executives receive many many more options of course. These stock options has some conditions and they are different for every company, but my options are as follows.
- Exercise price – MSFT stock was $56 on 1/1/2000 and I can buy MSFT at this price when the vesting period.
- vesting – The options are vested in 5 years. This is when I can exercise the options.
- expiration date – The options expire in 10 years if I don’t use it.
If the stock keeps going up, and on 1/1/2005 MSFT stock is $100/share. Then I can make a lot of money. I would buy the 10,000 shares of MSFT at $56 and sell them at $100. In effect, I would have made 10,000 * ($100 – $56) = $440,000 pre-tax.
Unfortunately the real world was a different story, on 1/1/2005 MSFT stock was $27 and the stock options are worthless. The options expire on 1/1/2010 and during this 5 years period, MSFT has not gone anywhere near $56. In fact, if I work for MSFT since 2000 and receive stock options every year, I would not have made much money from them. See the price graph below.
I do not work for Microsoft, but many large tech. companies has similar chart during the last 10 years. Of course, there are exception such as Google, but they are a new dominant force. Apple also did quite well this past 10 years, but there are many more companies that went side way such as Microsoft, Dell, Cisco, Sun, and Oracle.
Pitfall – If you have stock options. Do not exercise and hold the stocks. During the dot com run up, some coworkers wanted more company stocks because the price kept rising. Let’s look at MSFT again, but go back 5 more years. In 1995, MSFT cost $4 and Joe programmer was awarded 1,000 options. His options became exercisable on Jan. 2000 and the price is $56. He wants more shares so he can let it ride and save on tax. You pay tax when you sell the shares, not when you exercise (ISO.)
Exercise on 1/1/2000 – He paid the company broker $4,000 and received 1,000 shares of MSFT.
At that point, the market started to turn down and by April 2000, MSFT dropped to $30/share.
Joe programmer sold at $30 and still made $26,000. 1,000 shares * ($30-$4). However if he just sold it on Jan. 1st, he would have made $52,000 then he could have used this money to invest in different companies. More importantly, that $4,000 out of his pocket should have been invested elsewhere. That’s the opportunity cost of exercise and holding.
retireby40′s strategy on stock options
- Never exercise and hold the shares. This is putting too many eggs in one basket. The company already provides pay check, bonus, benefit, SPP, and more. I try to keep company holding to 5% of my portfolio or less.
- Exercise at the highest price between the vesting date and expiration date. Easy to say but, practically impossible to do. Sell the shares on the same day and then use the profit to diversify.
- This is free money so you can gamble with it a bit. If you think the stock can go up, just hold it until it hits your price point. Even if it drops, you won’t loose any of your own money.
Then again, I haven’t made much money from company stock option. If you have better strategies, please share them.