Have Equity Compensation? Strategies to Handle Stock Market Volatility

If you’re an investor in the stock market, it’s likely that you have experience with volatility, which often can strike unexpectedly. However, if you are the owner or recipient of equity compensation and employee stock options, you may not realize that volatility can have even more of an impact on your financial future.

A dramatic stock price change can quickly alter the value of your stock options and other equity compensation, whether positively or negatively. With careful planning, however, you can think through how market volatility should be managed to mitigate the threat to your stock options' value.

Don’t Get too Wrapped Up in Day-to-Day Fluctuations

Stock options and other types of equity compensation are tools companies use to attract recruits, inspire employees and boost retention. The hot stock market in recent years has added to their appeal.

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Accordingly, your financial plan may have included plans to exercise your stock options (by buying shares of stock at a pre-determined price set by your option agreement) or selling the shares you already own, turning company stock into cash that can be used for other needs. It is only natural for increased volatility to cause you to re-evaluate your plans.

When things don't go well for your company stock, it's easy to become preoccupied with watching the stock price and grow concerned about short-term volatility and its impact on the value of your equity compensation. But remember that stock compensation is often a long-term deal. The Harvard Business Review (opens in new tab) reported that option grants have dramatically strengthened the link between pay and performance, besides encouraging recipients to adopt a longer-term perspective toward options.

If you get equity compensation, rather than keeping an eagle eye on stock prices and market fluctuations, consider the following smart approaches.

Be Realistic about Stock Prices

It’s important to maintain a realistic outlook on the value of your company stock. When the stock price rises, it’s easy to become excited about the prospects for further growth and an increased value on your statements. But you only “capture” the value of your stock gains if you decide to sell your shares.

If the stock price declines, the value of your stock options and restricted stock may drop too, leaving you with less than what you had hoped for, and negatively impacting your financial plans. It makes sense to monitor your stock options during down periods, because several planning opportunities may exist.

For example, you may want to evaluate several factors during down markets, including their effect on your alternative minimum tax (AMT) obligations, if any. If you exercise now, what will that mean for your AMT obligations? You many also want to look at the holding period of the shares you own and evaluate whether you should hold for a long-term capital gain. Typically, if you hold an investment for at least a year from the date it was purchased, it is considered a long-term gain and taxed at preferential long-term capital gains rates.

Timing both your exercise of incentive stock options (ISOs) and your sale of stock is crucial if you receive and want to manage AMT and benefit from the long-term capital gains tax treatment. To obtain preferential tax treatment, ISOs require you to sell your shares at least one year past the date you exercise the shares and at least two years past the grant date.

Some ideas for ISOs may include exercising your options as early in the year as possible. This gives you the chance to time the actual sale based on the stock performance during the year. Another strategy is exercising options at the end of the year, so you can more accurately gauge your total yearly income and probable tax bill.

Diversify Your Holdings

During periods of stock price volatility, it's hard to think about selling and diversifying if your assets are climbing. However, diversifying your holdings could protect you from the down periods in your company or industry or the whole asset class. Even during this past year’s volatility, many stocks flourished, while others or entire industries floundered when unemployment skyrocketed. While diversifying doesn’t mean you won’t have any losses, a mixture of assets may help avoid a steep decline when volatility hits.

Ultimately, there is risk if you bundle all your assets in one stock — whether it's your own company’s stock or any other. Concentrated equity may jeopardize your financial future.

To manage this risk, it’s important that you identify how much of your total assets are invested in a single company, determine how comfortable you are with that risk, and then work intelligently to mitigate those risks in a tax-smart, time-sensitive manner that balances your investment risk and financial planning goals.

Plan for Good Times and Bad

As an owner of employee stock options, understanding the potential negative or positive effects of market volatility on the value of your stock options can protect your financial future. By establishing a sound financial plan, paired with a continued reality check in flat markets and times of increased market volatility, you can achieve a beneficial outcome rather than succumb to common fears.