Nobody likes to see their stocks go down. But for employees who get paid in part through stock options, stagnant and falling share values mean a big pay cut.

When most people think of stock options, they picture highly paid corporate executives for whom stock options are just part of a lush compensation package. It's hard to feel sorry for company leaders when their options end up worthless. After all, they bear responsibility for the decisions that determine whether their companies will succeed and prosper.

But stock options aren't just for the executive boardroom anymore. Technology companies like Microsoft (NASDAQ:MSFT) and Yahoo! (NASDAQ:YHOO) used stock options to attract talented employees while preserving precious cash. Now, though, you'll find broad-based employee stock option plans not just at tech firms like Cisco (NASDAQ:CSCO), but throughout the business world, at companies including PepsiCo (NYSE:PEP), Starbucks (NASDAQ:SBUX), and Southwest Airlines (NYSE:LUV). The National Center for Employee Ownership estimates that 9 million employees have stock options as part of their compensation.

A double-edged sword
When the economy is strong and stocks are performing well, stock options provide huge incentives for employees. Whereas simply increasing salaries or benefits rewards individual performance, stock options give every employee a sense of ownership in their company, helping give everyone a stake in the successes and failures of coworkers throughout the business. And unlike fixed-cash awards, stock options give employees the potential for huge gains -- as those who worked for (NASDAQ:AMZN) during the late 1990s can attest.

Stocks, however, don't always go up, and falling share prices make the shortcomings of stock options clear. If employees' options prove to be worthless, they'll focus more on what they gave up to get them, and workplace morale will drop. And unlike executive-centered options plans that often end up repricing underwater options to restore their value, making adjustments to companywide options plans seem to occur much less frequently.

The best of a bad lot
If you have stock options with your employer at much higher prices than where your stock currently trades, there's no magic solution that will suddenly make them valuable again. Instead, like an outside investor, you have to look at your employer's business impartially and decide whether you think its prospects are favorable.

One good thing about stock options is that since they typically vest over several years and can expire as long as 10 years from when you get them, you'll often have enough time for your company to recover from a bad economic cycle and see its stock price rise again. So if you determine that your employer is suffering only a short-term setback, there's a decent chance that your options may someday have value again.

However, if you think your employer's problems aren't going away anytime soon, you'll want to consider alternatives. Here's a plan to follow:

  • Do some research. Talk to contacts at other companies in your industry to find out what their pay structure is like. If cash salaries elsewhere are significantly higher, then you're essentially paying thousands for options you think won't be worth a dime.
  • Hedge your bets. With both your paycheck and the value of your stock options dependent on a single source, you have to be careful about the potential catastrophe to your finances if your employer goes under. Just as buying too much employer stock is generally a no-no, having too much money locked up in stock options exposes you to huge risks. If you have old options that are in the money, exercising them early can be smart even if your stock is off its highs.
  • Run the numbers. If your employer's stock is publicly traded, you may be able to see what value the market is giving to options similar to yours. You might even be able to use some options strategies to help reduce your risk.
  • Avoid catastrophe. As some learned in the tech bust, you need to consider taxes when exercising options. Making a mistake can mean paying thousands in taxes on gains that ultimately disappear.

Creating a financial plan around stock options presents a unique set of challenges, especially when the underlying stock is struggling. But even if things look bleak now, you never know when a market recovery could suddenly get your option holdings back in the black.

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