I have been doing a bunch of thinking about when a good time to sell an investment is. The reason is because I was speaking with an acquaintance about some stock options that he had with his company that he has only exercised once in his time with the company (7+ years).
It was a few years ago and since that time, the stock has appreciated 5 times the price of his exercise. Essentially, he “lost” a lot of money because of selling too early. He therefore decided that he would never exercise again until the grant was close to expiring. In his mind the stock will keep going up.
Ignoring the obvious flaws in his thinking in terms of the stock in a never ending trek upwards, it got me to thinking about when to take some profits on an investment gain. I don’t see the problem, if you are sitting on huge gains, to simply take some of the money you have gained off of the table. Even if you don’t have another use for the money right away, take some out to solidify your gains. At the very least this ensures that you enjoy the run up in stock price – because just as easily the stock can turn around and begin that awful, never-ending trek downward that becomes especially painful if you knew that you had a massive gain at one point (remember the tech boom i.e. Nortel).
There is a reason greed is one of the seven deadly sins…
I see your point – if you liquidate early, you have more control over when to sell, whereas if you wait until the expiration period, you may find yourself selling in a tough market. It’s obviously better to sell at peak, and with a profit, than be forced to liquidate at an inopportune moment (or simply forfeit the options because they are underwater).
Ideally, what you would be able to do is sell the option, rather than exercise it, because you would get the benefit of the in-the-money cash, plus the premium for having a fixed-value option that might still have four YEARS before exercise (this is worth several dollars all by itself). And this is why your friend, in my opinion, has a point. (If the company pays dividends, the value of this premium is considerably smaller, so exercising makes more sense).
When you exercise a 10 year or 7 year fixed value option years before it expires, you definately guarantee a profit – you wouldn’t be exercising otherwise – and some profit taking is undoubtedly prudent, particularly if a wasting asset represents a huge portion of your net worth. You should protect your downside. The problem is, you also surrender the option premium – the value of the fixed call value for an asset that is likely to increase in price over time, and is therefore likely to trade at a higher value at some point in the future. You tend to maximize the value of your options if you wait until very near the expiration date. Stocks in successful companies tend to rise over time, as retained earnings beget increased capital, which begets higher earnings, which begets more retained earnings, and so it continues. Compounding in the fashion means that stock prices tend to rise.
Now, if everyone and his brother in the company are, like you, sitting on 7-year fixed value options, you should think about exercising earlier, because their options and yours are going to be expiring at the same time, and everyone, in a rush to get their money, is going to be minting stock, and driving down prices. But even here, we need to think carefully, because that major selling after a lockup period often tanks the stock right away, and, if the company it truly healthy, it may recover after the initial round of selling.
Too bad that fixed value options issues as compensation are non-transferable, so you can’t simply sell the option.