When Should I Exercise My Company Stock Options?
In a recent post, we addressed the planning enigma that company stock grants pose for corporate executives and other employees. Non-qualified stock option grants pose an even trickier problem. In our view, it can only be solved by actively managing the options. Here’s why.
The value of a stock option has two main parts: its intrinsic value if exercised right away and its time value, which reflects the possibility that it may be more profitable to exercise it in the future.
Since the exercise price of a company stock option typically equals the stock price at the time the option is granted, the option has no intrinsic value then, and its time value is 100% of its total value. If the stock price rises, the option’s intrinsic value increases. The option’s time value falls as the option nears expiration because there is less time left for it to benefit from further stock appreciation. Just before expiration, time value falls to almost 0% of total value.
The optimal time to exercise stock options is generally when their time value is between about 30% and 10% of total value, as the Display below shows. The line represents the risk-adjusted potential return of exercising the option at various ratios of time value to total value. The line begins to plateau around 30% and reaches its peak around 10%, the calculated inflection point, when the option’s upside return potential is no longer attractive versus its downside.
These ratios could be reached at any point in the life of the option. If the stock price skyrocketed soon after the option’s first vesting date, the 30% ratio could be reached quickly. Our research suggests that rules of thumb, such as “Exercise 10-year options at year seven,” don’t work.
Our research also suggests that actively managing company stock and option grants can dramatically lower the target financial capital you need to fund your retirement and boost the odds of financial success. To do so, you or your advisor need to actively monitor the options’ value.
If you are sensitive to risk because you are building capital to fund must-have spending in retirement, exercising the options when time value reaches 30% of total value is a generally good idea.
If you are seeking to maximize returns (perhaps if you plan to use the options to pay for nice-to-have expenses), you might choose to hold the options until their time value falls to just 10% of total value.
We estimate that holding a $100,000 stock option grant until expiration in typical markets would realize $6,000 in value after taxes, inflation-adjusted, if you’re in a high tax bracket. Actively managing the options and exercising them when the time value is 30% of total value and reinvesting the proceeds in globally diversified equities would net $22,000—almost four times as much.
Our research also suggests that the active approach increases the odds that the stock option would yield some value, rather than expire worthless. Passively riding an option position until expiration would result in a positive value 53% of the time, in our analysis. Actively managing the option position to exercise them when time value is 30% of total value increases the odds to 65%.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.