Are You Making These 5 Mistakes with Your Stock Options?

This post was originally published on Beyond Your Hammock

Stock options are a type of equity compensation, or a way for employers to reward key employees beyond the usual paycheck.

Equity comp can allow you to participate in the growth and upside potential of the company you work for, and is often a great tool to leverage to accelerate your progress toward building wealth.

But it’s easy to make big mistakes with your stock options if you’re not careful. While options, RSUs, and ESPPs can provide serious financial upside, you have to understand what you have and how to use it to your advantage — as well as know the best ways to optimize these benefits.

Here are some of mistakes you could be making with your equity compensation right now, as well as what you can do to avoid these potential pitfalls in the future.

Mistake 1: Failing to Read the Plan Document for Your Stock Options

Your plan document for your stock options is kind of like the owner’s manual. It’s important to have it and review it, because it contains all the facts you need to know about your options and how they work.

Too often, we see people who have stock options or another form of equity comp — but they have no clue what they have, if there are any limitations, and what specific rules their company might use when it comes to granting this kind of compensation.

And yes, the details matter. Because incentive stock options and non-qualified stock options are not the same, and may receive different tax treatments.

Same goes for RSUs, or restricted stock units — which behave very differently than either type of stock option.

And then you have ESPPs, or employee stock purchase plans, which are again different than the other types of equity mentioned above.

This is why your plan document is so important. It should tell you exactly what kind of equity compensation you have and all the rules for what you can do with it, when, and if there are any restrictions or exceptions.

Read it carefully and make sure you fully understand all the details. If you don’t understand something, the first step is to reach out to your HR department to ask for help.

A more advanced step, however, is to work with a financial planner with experience in setting strategies for equity compensation.

They’ll be able to provide expert recommendations about what to do with your options, RSUs, or ESPP shares in the context of your entire financial plan, which takes your goals, tax situation, and more into account when figuring out the absolute best moves to make with your equity comp.

Mistake 2: Ignoring the Concentration Risk You May Face

FINRA describes concentration risk as “the risk of amplified losses that may occur from having a large portion of your holdings in a particular investment.”

Most of the time, we avoid concentration risk in investment portfolios through proper diversification across global markets. But this particular investment risk can be harder to manage if you have equity compensation, because you usually start automatically building a concentrated position in a single stock through contributions to ESPPs or grants of RSUs or stock options.

It might not be your intention to hang on to too much of one stock, but because vesting schedules and contributions are usually set in advance, it’s easy to end up having a big percentage of your overall investment portfolio be represented by your company’s stock.

Concentration risk is something you likely want to avoid no matter what kind of stock it is — but when it comes to your employer’s stock, this can become even more hazardous than normal.

Not only is a large percentage of your portfolio tied up in a single stock, but that same company is also the one that signs your paychecks.

When both your income and your investments rely on the good performance of your employer, you expose yourself to potentially catastrophic downsides.

Generally, I suggest that people don’t keep more than 5% of their net worth in any one stock. When it comes to your own company that you also rely on for regular income via a steady paycheck, you might want to hold even less in that stock to better diversify your financial life.

The reason that so many people struggle with making this mistake with stock options is that it’s really tempting to want to exercise and hold shares in hopes that your company will be the next one to go big.

And this can happen; I understand that the upside is significant. But you’re also risking the downside here, too.

And if experiencing the full extent of that downside — like a steep decline in the value of the company stock plus potential loss of income if you were to lose your job — would break your financial plan, then you literally can’t afford to gamble on holding too much of a single, concentrated stock position.

That’s not to say investing in your company is always a bad idea, just that you cannot ignore the risk you take when you do so. The mistake is not evaluating concentration risk at all, and failing to account for the potential impact of being exposed to it.

Your financial plan should account for how much risk you can take on here, or if it makes more since to simply exercise and sell options, units, and shares when you can to lock in gains.

Mistake 3: Missing Out on the Expiration Date

Mistakes with your stock options don’t necessarily happen because they’re overly complicated and you didn’t understand what to do with them. Although they can get tricky to manage, most of the mistakes I see people make come from simply not paying attention.

Like not paying attention to expiration dates or trading windows, and then missing them. This is where your plan document can come in handy again: it should tell you all the details on the deadlines you need to know.

You’ll need to review your plan doc or talk to HR to know your specific timelines and dates to note, but in general, understand that stock options are a “use it or lose it” sort of benefit.

Let’s say you hold company stock and your options are in the money — meaning, they’re worth more on the open market than the price you pay when you exercise options and buy shares.

You could exercise your options and purchase the underlying stock for less than what it’s trading at on the exchange… which means you could turn around and sell the shares for more than you just paid for them, therefore generating a profit.

But your options don’t have endless shelf lives. Whatever options you old have expiration dates, and if that date comes before you choose to exercise your options… that’s too bad.

The options expire, you lose your chance to exercise them, and ultimately you miss out on an opportunity to increase your net worth.

Don’t let this happen to you! Know these deadlines and have a plan for what action you’ll take before they hit.

Mistake 4: Letting the Tax Tail Wag Your Stock Option Dog

When you exercise your stock options, what you’re doing is exercising your right to buy company stock at a certain price — and usually at a discount (15 percent is fairly common).

When you exercise your stock options, you have a choice about what to do with them:

• Sell the shares immediately
• Hold the shares for a period of time

If you sell your shares immediately, you get to lock in the difference between what you paid and what you can sell them for as an immediate gain, or profit.

This sounds great, and usually is for people who want to take money out of a concentrated position (a single stock) and reinvest the gains into a more diversified investment (like a portfolio that’s properly allocated and diversified across many different positions).

But there are a few things that people can see as downsides to an exercise-and-sell strategy. For one, the stock price could go up even higher in the future, so you miss out on making even more money.

I don’t think this reason alone is good enough for hanging on to shares you bought through an options exercise. (See Mistake #2 on Concentration Risk!).

When you exercise and sell at a profit, you will also trigger a tax bill on that gain. This is what many people claim as the reason to buy and hold.

If you hold your shares for a certain period of time (1–2 years or more), then you’ll still be taxed if you do eventually sell and lock in a gain — but at that point, you’ll be taxed at lower long-term capital gains rates.

But at the end of the day, you’re still paying taxes on gains you might receive — and if you hold shares for a period of years, you’re increasing the market risk and volatility you expose a portion of your portfolio to while waiting for a small tax advantage.

The mistake here is just assuming having your gains taxed at a lower rate is immediately and always the best move to make — because that’s simply not the case.

You need to look at your specific financial situation, your goals, your overall investment strategy, and your own comfort level with risk to determine the true best moves to make with your options before you decide to exercise and sell or exercise and hold.

Mistake 5: Not Setting a Strategy for Your Stock Options

That also gets at the number-one mistake people make with their stock options: not having a plan at all.

Without a plan or cohesive strategy, it’s hard to know you’re doing the absolute best thing for you. Lack of a strategy also leaves you more prone to making last-minute, emotional, or irrational decisions that you can’t undo.

Simply planning ahead of time allows you to get clarity on what you will do and when you’ll do it, so you can act when the time comes instead of making emotional decisions on the fly.

This makes it easier to act with confidence — and to make decisions that help add zeros on to your net worth over time.

Want more financial advice you can actually use? Check out Beyond Your Hammock, a fee-only financial planning firm that specializes in helping 30- and 40-somethings get clarity and start building wealth.