Biblical Option Harvest: Using the One Tenth Rule
Spencer D. McGowan, CIMA®
President McGowanGroup Asset Management
There are many methods for harvesting employee stock options. The bull and bear cycles of the years 2000 and 2001 demonstrated the need for a scientific method that takes advantage of share price increases.
The term “Biblical” is an easy way to remember the method for harvesting 10% of your option balance at each major rally in stock prices. Employee stock options are like bread. Waiting until next week to eat the entire loaf of bread may not prove beneficial.
The unprecedented prosperity of the 1990’s handed a perishable gift to loyal employees of America’s most successful companies: Billions of dollars in un-exercised employee stock options at a premium.
These employee stock options are almost always perishable. Most of them have a date of expiration.
Here are some definitions:
The exercise price is the price that the owner must pay the company for the stock. The market price is the current value of the stock. Therefore, the intrinsic value equation is:
Market Price X # Shares
– Exercise Price X # Shares – Tax Liability
– Transaction Cost
Key bear market point: If the exercise price is more than the market value, the employee stock option is not worth anything. These “valueless” periods can extend through expiration and cause great pain.
Another type of potential pain is the regret for harvesting too much, too soon, before a major rally.
Great joy results from a successful wealth building strategy.
Here is one rule we can use to harvest employee stock options:
If a major rally occurs, we recommend exercising 10 percent of your available employee stock option balance, taking into account those options that are not yet vested or granted. If your company stock makes a new historic high, you have experienced a rally and our exercise signal occurs. With employee stock option grants and vesting, a large balance is still maintained and harvesting occurs with new highs in the stock.
Another harvesting technique attempts to protect the long-term value of shares that you hold, or purchased through an exercise. If a company’s price is expected to move up more, we would rather keep the shares than sell. A useful technique is to harvest ownership only if a decline begins. This is known as a stop order.
For example, if the market value is 80 and rising, we can put an order in that says sell if it goes below 75. If the stock goes up, or stays above 75, the shares remain unsold. However, if a decline begins and the stock trades at 75, your order becomes a market sell order that may fill at an even lower price. The key is that you have a trigger to harvest, if a decline begins, with the intention to stay on board if the shares move even higher. You can also raise the stop order along the way.
If you own shares of a great company, picture harvesting just the fruit, but not the tree. We believe the best companies, with long-term growth in earnings, sales, and cash flow, are worth continuing to hold. The options are perishable fruit.
There are four tools needed to plan the harvest:
- A long-term price chart
- An annual report
- Your employee stock option spreadsheet from the company
- A statement of your current shares owned
Call us for an appointment to help build your long-term harvesting plan, 214-720-4400. The basic plan will take about one hour in our office.
This article pertains to Employee Stock Options, which are privately-issued contracts between corporations and their employees. This article does NOT pertain to publicly-traded, standardized equity options.
Spire Securities, LLC and McGowanGroup Asset Management are not tax or legal advisors.
Individuals should consult with a qualified tax professional to carefully plan for Employee Stock Option harvest tax issues, including the taxation as ordinary income and the ability for certain options (i.e. Incentive Stock Options) to convert to long-term capital gain status.
© 2001 McGowanGroup Asset Management