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Lesson 2. Why Options Are Important > The 30-Second Recap - Pg. 10

Why Options Are Important 10 Alternative Number Four The stock is selling for more than the option's strike price and you exercise the option and hold the stock in your portfolio. This strategy can help you build a nice portfolio of stock with a built-in profit. You will pay ordinary income tax (in the case of NSOs) on the difference between the option's strike price and the price of the stock on the day you exercise the option. No further tax will be due until you sell the stock. If you hold ISOs and exercise them under the guidelines, you will not pay any ordinary income tax and will only pay capital gains tax when you sell the stock. If this sounds complicated, see Lesson 10, "Taxes and Your Options," where I describe the tax consequences in more detail. This strategy only makes sense if you have decided that you want to own the stock and it fits your financial goals and needs. Anytime you can buy a stock you want to own at a discount, it is a good deal. However, you should consider this note of caution. Too many investors overload their investment portfolio with one stock. This can lead to disastrous consequences if something goes wrong at the company. The first principle of investing is diversification. Diversification allocates your investments in different stocks and in different industry groups. The idea is to protect you from severe losses if one stock or industry segment drops significantly. Plain English Diversification is an investment strategy that spreads your investments over a group of stocks or mutual funds representing different industry groups. Diversification seeks to pro- tect you from sudden reversals by one group of stocks. Stock bought through employee stock options can be a real bargain, but you should never have more than 10 to 15 percent of your portfolio in any one stock. When you find yourself approaching this limit, consider alternative 3 and use the cash to invest in other stocks or mutual funds. This same advice applies if you are participating in an employee stock purchase plan. These plans allow you to buy company stock at a discount. Some companies offer both an employee stock option plan and an employee stock purchase plan. Under these conditions, it is easy to find yourself owning a greater percentage of the stock than is prudent. I discuss employee stock purchase plans in more detail in Lesson 14, "Employee Stock Ownership Plans." The 30-Second Recap · Employee stock options can be used as an incentive or additional compensation. The employer will structure the program to accomplish its goals. · Companies use employee stock options as a motivation tool, although there is inconclusive evidence they work. · Valuing employee stock options is not always easy, especially for private companies. · How employee stock options fit into your overall financial picture depends on your goals and whether you want to own the stock or not.