Sell my stock? Exercise my options?

The following is not professional advice and is intended just to tell you things I've learned from our financial advisor. Consult your financial advisor before making any big decisions. Your mileage may vary. No warranty, expressed or implied. Blah blah blah.

OK, so lots of people want to know what's going to happen to stock prices -- especially if they own shares in a single company, as distinct from mutual funds and the like. Nobody knows, of course; just remember the time "When Genius Failed" (on Amazon, or Google "LTCM").

My financial advisor recommends against that -- the risk inherent in owning single stocks is not, for investors like me, sufficiently offset by the expected gain. But if you hold options -- for example if you've been granted options as an employee -- then you have a chance to reap some gain if the stock rises.

So when should you sell? Two answers:

1. if you need the money from the options right away; and
2. as part of a plan to diversify your portfolio.

The first one is obvious. But what does "need" mean? If you need a few thousand bucks, and you could afford to borrow that amount, should you borrow, or should you exercise and sell? I'll tell you: I don't know. But if for example you want a pile of cash for a down payment on your home (so you don't want to borrow it), that might be a case for exercising and selling. But see your financial advisor.

About diversifying the portfolio: Here's a strategy and some tactics that I use. My financial advisor suggests that I look at the amount of money available in vested options. That is, pick a day and say, "If I were to exercise everything I could and sell immediately, how much would I make?"

Exercise enough options (using whatever strategy) to make 25% of that amount, and sell the stock immediately. DO NOT HOLD the stock, especially if you have qualified options (or "ISO"s). Take your profits and put them into a diversified portfolio.

If you do that once a year, you'll reduce exposure to both upside and downside potential of that single stock. When should you do it? Well, if your stock has traditionally had 12-month highs in October in every one of the past dozen years, and it's never had a low in October, then do it in October by all means! But here is what I do.

In one year, I exercised my 25%-of-vested-dollars near the beginning of January. And near the end of December. The next year, exercise nothing. Here's the method to my madness. Suppose I exercise twice in 2005, and not at all in 2004 and 2006. For my 2005 tax return, I get a big bump in income. But there's no penalty, because the 2005 withheld is higher than my 2004 actual tax liability.

Normally when you owe a pile of tax like I did for the 2005 return, you want to make quarterly tax payments. But in 2006, there's not going to be any stock option exercise (especially there won't be any ISOs exercised) so there is no need for estimated tax payments -- in fact I'll get a refund on my 2006 return.

Then in 2007, I'll exercise in January and December, owe a pile of tax on my 2007 return, but again no penalty because my 2006 actual liability is lower than my 2007 withholding.

Now is January/December a good time of year as regards my company's stock? I'm not sure. But my company moves with the market, so if it's cheap, the market is also likely to be cheap, and since I'm basically buying mutual funds from those profits, it doesn't really matter.

Really, this strategy is all about managing risk; it's not about timing the market. Timing the market can lead to spectacular gains -- or spectacular losses. My performance as a market timer is atrocious so I fundamentally don't believe in it.