What You Need to Know about Stock Options

Contributed by: Nick Defenthaler, CFP®

As a professional, there are various ways you can be compensated for your work.  Although not as prevalent as they once were, stock options still exist in many different companies and can often be negotiated into your overall compensation package.  Stock options are intended to give you motivation and incentive to perform at a high level to help increase the company’s stock price which will, in turn, have a positive impact on the value of your own stock options.  There are various forms of stock options and they can certainly be confusing and even intimidating.  If you’ve ever been offered options, your initial thought might have been, “I know these things can be great, but I really don’t have a clue what they are or know what to do with them!” For starters, there are two common forms of stock options NSOs & RSUs.

NSO: Non-qualified Stock Options

Non-qualified stock options, or NSOs, have been around and very popular for decades.  The mechanics, however, can be a bit tricky which is partly why you don’t see them quite as much as you used to.  There are various components to NSOs, but to keep things simple, the company’s stock price must rise above a certain price before your options have value.  Taxes are typically due on the difference between the market value of the stock upon “exercising” the stock option and what the stock price was when the option was “granted” to you.  Upside potential for NSOs can be significant but there’s also a downside. The options could expire making the stock worthless if it does not rise above a certain price during the specified time frame.

RSU: Restricted Stock Units

Restricted Stock Units, or RSUs, have become increasingly popular over the past 5 – 10 years and are now being used in place of or in conjunction with NSOs because they are a little more black and white.  Many feel that RSUs are far easier to manage and are a more “conservative” form of employee stock option compared to NSOs because the RSU will always have value, unless the underlying company stock goes to $0.  As the employee, you do not have to decide when to “exercise” the option like you would with an NSO.  When the RSUs “vest”, the value of the stock at that time is available to you (either in the form of cash or actual shares) and is then taxable.  Because you do not truly have any control over the exercising of the RSU, it makes it easier and less stressful for you during the vesting period.  However, because the RSUs vest when they vest, it does take away the opportunity to do the kind of pro-active planning available with NSOs.

Stock Options and Tax Planning

As you can see, stock options have some moving parts and can be tough to understand.  There are many other factors that go into analyzing stock options for our clients and we typically also like to coordinate with other experts, like your CPA because tax planning also plays a large part in stock option planning. If stock options are a part of your compensation package, it is imperative to have a plan and make the most of them because they can be extremely lucrative, depending on company performance and pro-active planning.  Please reach out if you ever have questions about your stock options – we work with many clients who own them and would be happy to help you as well!

Nick Defenthaler, CFP® is a CERTIFIED FINANCIAL PLANNER™ at Center for Financial Planning, Inc. Nick is a member of The Center’s financial planning department and also works closely with Center clients. In addition, Nick is a frequent contributor to the firm’s blogs.

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US Stocks & the Federal Reserve - 2nd Quarter 2012

As the saying goes, “Don’t fight the Fed!” Many investment experts have noted the strong relationship between the market’s ups and downs and Federal Reserve policy. This chart, compiled by Doug Short at dshort.com beautifully illustrates the relationship between Fed intervention programs and the S&P 500. 

While Operation Twist is scheduled to end in June 2012, Federal Reserve board members have also started to use stated future targets for interest rates as a means to encourage market participants to invest in stocks. As recently as April 11th, Fed Vice Chair Janet Yellen indicated that the Fed’s “Zero Interest Rate Policy” could remain even past the initial 2014 target date. If markets stumble, some think that a third round of Quantitative Easing may also be possible.

There will come a time when markets need to stand on their own two feet. Based upon the words and deeds of the Fed, those days may be several years away.

Hat Tip: The Big Picture, Barry Ritholtz.

U.S. Stocks - 1st Quarter 2012

Last year the S&P 500 – a bell-weather for American stocks – was statistically unchanged from a price perspective.  When you add in dividends, the index was up 2%.  You may be feeling a lot more bumps and bruises from the year in stocks than a flat 12-month return would indicate.  Markets had wild swings and Ron Griess of the Chart Store (Hat Tip ritholtz.com) reports that 2011 was the seventeenth most volatile year for the S&P 500 since 1928.  Perhaps not surprisingly, 2008 and 2009 were even more volatile.  All of this has presented a behavioral challenge for investors with the temptation to time the market or get off the bumpy ride.

As with anything, it is very difficult to predict volatility.  It’s best to plan, though, for more ups and downs.  Volatility seems to come in patches with 15 of the 17 most volatile years for the S&P coming between 1929 and 1939 or between 2000 and 2011.  Managing your investment behavior through allocation planning, regular rebalancing, or the advice of an investment professional is critical to help avoid paralysis or bad timing.

Returns of large US companies surged ahead of their smaller peers. While large company S&P returned 2%, the Russell 2000, a common index for small companies, was down 4%.  The Dow Jones Industrial Average, even bigger than the S&P as measured by market capitalization, returned 8%.  Still, smaller stocks have outpaced large stocks cumulatively since March 2009 (when using the same indexes).

Many have watched for large companies to outperform due to compelling valuations and diversified revenue sources.  This trend may continue with strong profit margins, cash on the books, and still interesting valuations relative to larger stocks.

Dividend-paying companies, especially those outside of the financial sector, rewarded their investors handsomely in 2011.   Dividends fulfilled their promise last year helping both the total return of companies as well as raising interest from investors for their companies themselves.

We still like dividends for reasons Angie Palacios, CFP® I explained in a recent blog post.  Dividend yields are attractive relative to interest that bonds pay across the world.  Furthermore, as more boomers retire and seek a more steady income stream (no small feat in a low-yield world), a strategy that includes dividends may remain attractive relative to their cash-hoarding peers. *Dividends are not guaranteed and must be authorized by a company’s board of directors.