Options At Work

By Daniel Kadlec

Don't you just get sick thinking about all those Silicon Valley optionaires who lost much of their fortune in the tech meltdown? Perhaps not. Poor little not-so-rich kids. We should all have such problems, right? Turns out many of us do. The number of people holding employee stock options is exploding, up 10-fold to 10 million since 1992. And most option holders are in non-tech industries, where the programs are so new that many recipients haven't a clue how to manage this asset.

How clueless are they? In a telling survey, Oppenheimer Funds found that 37% of holders felt they understood Einstein's theory of relativity better than their options. A shocking 11% said they had allowed vested, in-the-money options (those with immediate cash value) to expire and become worthless. The knowledge void has brought employee lawsuits, even bankruptcies by those who grossly mismanaged their windfall, losing all in the bear market.

You don't have to be Einstein to manage stock options if you keep things simple. They bestow the right to buy stock from your employer at a preset price by a preset time. If the market price is higher, you pocket the difference. If the price is lower, the options are worthless but cost you nothing. It's a great deal, reserved until recently for top execs as a very tangible incentive to get the stock moving higher. How to keep it simple:

--Hold as long as possible. Stock options amount to an interest-free loan to buy stock, with zero downside risk. It doesn't get any better than that. Say you have options with a strike price of $20. The market price is $22. You could exercise to buy at $20 and sell at $22, pocketing $2 before taxes and fees. If you reinvest that $2 in a fund that goes up 10%, you'll make only an additional 20[cents]. But if you hold the option and your company stock goes up 10%, that same $2 more than doubles.

How? You have only $2 at risk, but it's a $22 investment. The company has essentially lent you $20. From the higher base, the 10% gain nets an additional $2.20. But don't hold on so long that, duh, your options expire. The normal period is 10 years, but when changing employers, you often get only 30 to 90 days.

--When you exercise options, sell the stock. Gains on non-qualified stock options (the kind most people get) are taxed as ordinary income at the time the options are exercised. It's tempting to exercise options and hold the stock a year to get the lower capital-gains tax rate on future appreciation. But that requires putting up cash, which you could lose if the stock goes south. Why? You would end up owning the stock, not the options, and thus would be vulnerable to any losses the market threw your way. Choose a "cashless exercise," and you'll never have to worry about market risk or unpaid tax.

--Think total portfolio. If you'll get more options and you have company stock in a 401(k) plan, it may be wise to cash in early to diversify. If your company isn't exactly on a hot streak, stifle your emotional attachment and cash out of that dog. "Think like an investor," says Mark Sakanashi, co-author of Your Stock Options, to be published in July. Don't buy other stock in your industry if you have ample exposure through options.

Keep it simple, and who knows? You just might retire early.

See time.com/personal for more on stock options. Dan is part of CNNfn's Money Gang each Tuesday at 2:15 p.m. E.T.