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Stock Options 101 – Strategy For Managing Risk

Despite the relatively positive progress made on the economy in recent years, the public, and investors remain skeptical of the markets and the country’s economic health in general. According to HCR Wealth Advisors, although we are currently in a bull market, the valuations of stock do not necessarily reflect the overall economic health. Additionally, many funds continue to move money out of equities and into bonds. Low stock valuations and a reluctance to invest in the market reflect a general sense of dread that looms over consumers and several financial analysts. Discussions concerning the next anticipated recession and when the next bubble will burst are dominating the headlines and injecting fear into the hearts and wallets of consumers.

While the economic situation is not nearly as bad as portrayed in the media, the compulsion to fret over a future recession could have negative effects on consumer spending and the markets. The more consumers are plagued with warnings about the inevitable collapse of the economy, the less likely they will be to continue spending and could cause a plummet in the stock market. Along those same lines, investors will shy away from equity and stock opportunities in favor of bonds and cash equivalents. This is dangerous behavior to encourage on a nationwide scale because psychological and emotional reactions to perceived economic challenges can actually bring about the recession that the public unnecessarily fears in the first place.

The advantage of this situation for investors is that they can continue to invest and find stocks at a good value before the valuations for solidly performing stocks eventually go up. Of course, some investors may take a middle ground approach of maintaining a slight bias towards bonds and cash equivalents while still capitalizing on the anticipated rise in stock values before the public’s perception catches up with reality.

Many people think that options are confusing and too complicated, but that doesn’t have to be true. HCR Wealth Advisors educates its clients on investment strategies as a registered investment advisory firm. This is what people need to know about the options trading.

The two types of options are puts and calls. When the client buys a call option, he or she has the right (but not the obligation) to buy a stock at the strike price any time before the option expires. On the other hand, with purchasing a put option, clients have the right to sell a stock at any time before the expiration date.

The biggest difference between stocks and options is that stocks give you a small piece of ownership in the company. Options are just contracts that give clients the right to buy or sell the stock. Another important part of options trading is that there are always two sides for every option transaction; for every call or put option purchased, there is always someone else selling the option.

Trading Stocks and Options

When clients wish to sell an option, they create an opportunity, and security, that didn’t exist before, which is also known as writing an option. This explains one of the main sources of options. Writing the call means that the client is obligated to sell shares at the strike price any time before the expiration date if the purchaser of the call option decides to exercise it. However, when the client writes a put, he or she is obligated to buy shares at the strike price before they expire if the purchaser of the put option decides to exercise it.

The expiration date is a certain date that all stock options have. Typically, call and put options expire up to nine months from the date the options are first listed for trading. LEAPS or longer-term option contracts are also available on many stocks, and they can have expiration dates up to three years from the listing date.

Options expire at market close on Friday, unless this day falls on a market holiday. In this case, expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month and weekly options expire on each of the other Fridays in a month.

Trading stocks can feel like playing blackjack being in a casino. You are in essence playing against the house, and if everyone is lucky, everyone wins. Trading options can feel more like being at the racetrack. Each person bets on a winner against the other people there. So just like the horse track, trading options is a zero-sum game – the option buyer’s gain is the option seller’s loss and vice versa.

There are two styles of options. Most exchange-traded options are American-style, and all stock options are American-style, which means they can be exercised at any time between the date of purchase and the expiration date. A second style is a European-style option (many index options are European-style) which can only be exercised on the expiration date.

The bottom line is that options can be a good risk management tool for some investors. It can be beneficial to use them for inexpensive leverage in trades or for hedging purposes. HCR Wealth Advisors know how options work and they can evaluate managers who use them.

As a part of creating personalized financial strategies for its clients, HCR Wealth Advisors does not typically use options directly in client accounts unless they seek to reduce exposure in a concentrated stock position without having to sell and deal with the tax consequences.

Company Issued Stock – RSUs, NSOs and ISOs: Protecting Clients Against Risk

For people who work for companies whose stock is publicly traded, they may benefit from a compensation structure that grants them stock in the company, inform them of restricted-stock (RSUs), incentive-stock options (ISOs), and non-qualified options (NSOs). For people lucky enough to be in this situation, they can run the risk of maintaining a portfolio that is dependent on the success of the company. When someone has a concentrated position in the stock of one company, it can expose an investor to significant risk. Concentrated stock positions can, therefore, be described as having “too many eggs in one basket.”

Concentrated stock creates a problem as it makes a large portion of wealth dependent on the movement of one particular stock. According to research, the average stock tends to lag the market, and given that two-thirds of the average stocks underperform the market, this should be a reason enough to diversify and seek different investment choices. Clients should think about the liquidity and valuation of the stocks to determine how quickly they can be sold, considering investments and tax effects.

RSUs, which are just like owning shares in a company, but they vest over time, can be sold when vested, but are taxed as ordinary income compensation when they vest. NSOs are treated as ordinary income according to their market value and the vesting schedule. ISOs do not generally trigger a taxable event upon vesting or exercise. Instead, they get taxed when the resulting stock is sold and treated as a long-term gain if the stock is sold more than one year after the date of exercise and two years after the date the option was granted. According to some analysts, ISOs have many tax advantages over NSOs for employees, but with these advantages come stricter rules regarding the granting of ISOs.

HCR Wealth Advisors has experience working with public-company executives and employees at all levels to integrate their company equity compensation plan with their retirement accounts and overall financial plan.

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