Lots of stock options have become valuable in the recent stock market rebound. When should you exercise and when should you sit tight? Systematic planning is required to answer that question.
With the S&P 500 price index up almost 145% from its 2009 low as of May 22 this year, many vested stock options are “in the money,” or potentially worth exercising. So, many option holders now have to decide: Which of their options should they exercise and when?
Our research has found that there is an optimal time to exercise each option that is in the money. The time depends on the option’s price and the owner’s accumulated wealth.
An option’s price consists of two components: its intrinsic value and its time value. The intrinsic value of an in-the-money option is simply the difference between its exercise price and the current stock price. For example, an employee option with an exercise price of $10 on a stock selling for $12 has an intrinsic value of $2. Time value is more complex and can be calculated using various financial models. But fundamentally, it captures the probability that the option’s intrinsic value will increase before expiration.
Now, let’s consider the hypothetical case of Megan Grant, a young executive, who received seven-year stock options from her company in February 2008 that permit her to buy shares of company stock at the then-current price of $40. After plummeting in the credit crunch of 2008 and early 2009, the stock has climbed up to $54; so each option has an intrinsic value of $14. As for the option’s time value, we calculate it at $4, which is 22% of its total value of $18 ($14 plus $4).
Is it time for Megan to exercise her options? She’s not sure, since she believes the stock can go much higher by the time the options expire in 2015. Also, she would like to avoid paying immediate taxes on the gain at ordinary-income rates.*
But our financial modeling suggests that when the ratio of an option’s time value to its total value falls below 30%, it’s not worth taking the risk that the stock might decline sharply. Since Megan is still building her “core capital” (the amount she’ll need to secure her spending needs throughout her life), exercising the options and immediately diversifying out of the stock position would, in our view, be the better course.
If Megan had already reached her core target and had surplus capital, she could have taken the extra risk of holding an option with a lower ratio of time value to total value—as low as 10%, according to our planning tools.
In any case, we think holding on until the last day before expiration is never optimal, since the risk of giving up potential option profit becomes too great. Indeed, we estimate that 40% of all options granted expire worthless. That’s a high price to pay for wishing and hoping.
In working with clients seeking to actively manage their employee options, we rank the awards in order of lowest to highest ratio of time value to total value. And while there are many factors to assess in each client’s situation, we often recommend considering exercising options whose ratios are below 30% and holding the rest for further appreciation potential.
*The options discussed in this blog are non-qualified, so the profit upon exercise is taxed as ordinary income. Non-qualified options are more prevalent than Incentive Stock Options ( ISOs), which offer potential tax benefits from not selling the shares immediately upon exercise.
The views expressed herein do not constitute and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-manager teams.