Exercising your stock options? Read this first.

The stock market rise has put stock options front and center. Just like in previous booms, companies are trying to attract talented workers by granting them an option to buy company stock at a low price, which workers can sell for a much higher price if the company goes public or gets acquired by a bigger company.

Unfortunately, many employees still lack a strategy for exercising their stock options, which could prove to be disastrous when tax time rolls around.

For many recipients of stock options, a “lottery mentality” still holds sway when choosing how to exercise and sell stock options — they cross their fingers and hope the stock price increases so they can use the windfall for a big vacation or major update to the humble abode.

Others wait and wait, until their options are expiring and they are forced to sell before they lose all their value. Part of this mentality was born during the dot-com bubble era of the late 1990s, when stock options were seen as retirement golden tickets because of their meteoric rise in value.

Sadly, many of these hoped-for riches evaporated when the tech bubble popped, and employees who had been granted potentially lucrative options to cash in company stock were left with worthless paper because they had held on for too long.

Having a process-driven strategy is vital when evaluating your stock options, so that you can make the smartest possible financial decisions. Here are five important questions to ask before exercising and selling your stock options.

When do they vest?

It’s important to understand when you will actually acquire the shares. Just because options are granted does not mean you have received an immediate bonus. A typical vesting schedule is over four years, with one-quarter of shares vesting after each year. Once the shares are vested, you can exercise and sell to take that long-awaited trip to Hawaii.

What is Uncle Sam’s cut?

If you are earning a high income, exercising and selling your options in the same year virtually assures the stock is taxed at an elevated rate (25% federal up to 39.6% plus your state tax). But if your income is variable and there’s potential for lower income going forward, this could sway you to wait and sell, when you could be taxed less. If your options are expiring soon, you will not have as much of a choice, but you still may be able to spread it over several years to stay in a lower tax bracket.

Consider how long you plan to hold the stock after exercising. If you can hold longer than a year, the stock may qualify for capital gain taxes, which is likely lower than ordinary tax rates. However, this decision involves risk. If the stock price falls after you exercise, even though your stock options may then be worthless, you could still be subject to the Alternative Minimum Tax.

This is where knowing if you hold Incentive Stock Options (ISO) or Nonqualified Stock Options (NQSO) is essential. Any gains on ISOs that occurs after you exercise, if held for a year, are taxed at capital gain rates. Be aware, there may be a difference in the grant price and the fair market value when exercising. This is known as a bargain element and is used in the AMT calculation.

How big is too big?

When stock prices start to increase, options can quickly become the largest holding in a portfolio. Because of the grant price, options have a great deal of leverage, meaning they can be worthless for years before rising suddenly and dramatically if company shares become a hot commodity. Options that were worth nothing one day can be worth thousands of dollars the next.

Therefore, the concentration risk has to be considered so that too much of your portfolio isn’t dependent on a fluctuating stock price. At this point, it becomes equally important to consider the valuation metrics and future growth potential of the stock. If the stock is over 10% of the overall investment portfolio, this might become one of the more important reasons to think about cutting some exposure.

Having a double-digit allocation to your company stock amplifies the potential outcome — good or bad. We saw countless examples of complete wipeouts in 2000, when many technology options lost their value overnight.

What’s the potential?

Because you are likely still working at the company that is granting you stock options, be aware of the bias you may have about your company’s growth prospects. Spending some time investigating the fundamentals of your company’s stock (or finding someone who can) will help in your decision-making.

Good questions to ask include: How quickly have sales been growing? How profitable is the company? Is the company an acquisition target? Who else is an owner of the stock or has been buying/selling the stock? What type of competition does the company have?

Adding analysis of the current valuation metrics (P/E ratio, P/S ratio, high-quality measures, risk measures) all should be part of your decision of how much you plan to sell.

Is there more stock coming?

Often when stock options are owned, employees will have restricted stock units as well as access to an employee stock purchase plan (ESPP). If the vesting schedules are defined, you will have a good idea of the share amounts that may be coming your way.

This should help you establish target prices at which to exercise and sell a portion of your stock holdings, especially if you are making decisions in the rest of your portfolio based on the amount of company stock you hold.

By analyzing these factors before you click “sell” on your next set of stock options, you increase your chances of getting the most out of your options, and setting yourself up nicely for the future. You may also seek help from a fee-only financial planner to assist in your decision-making.

Learn more about Chad on NerdWallet’s Ask an Advisor.