-- Most people exercise their stock options way too early --
-- You should wait as long as possible --
-- Capture leverage; minimize taxes --
We’re going to attempt to answer the toughest question related to Stock Options: “When should I exercise?”
First, what is a stock option? A stock option is simply a right to buy a share of stock at an agreed upon price. The price you pay for that stock is called the exercise price, and it’s equal to the company’s stock price on the day of grant. So, if the company’s stock price doesn’t go up the option is worthless, but if the stock does go up, it can be quite valuable.
Executive Summary
THE RULE: “Hold your options until they expire”
This is the basic rule. There are nuances and exceptions, but this is the general rule. There are two reasons for this:
-Option Leverage. Options are like leverage; they provide the ability to earn money without laying down cash. But once you exercise you lose that leverage. You want to maximize your option leverage.
-Double Taxation. When you exercise you pay tax. Then you pay tax again on appreciation of the stock - or any investment - you purchase subsequent to the exercise date. This is double taxation. You want to avoid double taxation.
There are a few exceptions to The Rule, when you should perhaps exercise earlier:
1.You need the money.
2.You need to diversify your portfolio (and I mean really need).
3.You believe the company’s business is in a long-term decline. And if this is the case, you may want to look for work elsewhere.
Why I wrote this?
I spend a lot of time today and in my past corporate life explaining to people why it is beneficial for them to hold onto their stock options as long as possible. Stock options are a significant part of compensation at Netflix and other Silicon Valley companies, but there is little to no guidance explaining their value proposition. In a separate post I will explain why more companies should use options as compensation, but for now, my goal is to help those that own options understand that they need to hold on for the very long term.
The rest of this article is detailed charts, graphs and math to help explain.
What’s a Stock Option?
A stock option is a contract between you and the company that gives you the right to buy a share of stock in the future, but at an agreed upon price today. That agreed upon price you pay is called the exercise price and its equal to the stock price on the day the option is granted to you. Like Restricted Stock Units (RSU’s), stock options often have a vesting period, like 1 or 2 years and they usually expire in 10 years. So if your company’s stock is currently worth $8, your employer may grant you some options that have an “exercise price” of $8, which is the price you would pay to acquire a share of the company’s stock at any time over the next 10 years. So if the stock goes up to $20, you will pay $8 for a share of stock worth $20, thus earning $12.
A key difference between Stock Options and RSU’s are that options are worth nothing unless the stock price increases; the stock needs to appreciate higher than the exercise price. But RSU’s are always worth the value of the stock; so there is less downside with an RSU, as they always have some value.
Option Leverage
This is a tough concept to wrap your head around, so bear with me.
Every stock option you own increases in value as the underlying stock of the company increases. So if you own 10 options and the stock price goes up $10, then you just made $100. When you receive a stock option from your company, no money has come out of your pocket. But once you exercise that option you are laying down money to receive stock. And invariably THE NUMBER OF SHARES YOU RECEIVE IS ALWAYS GOING TO BE LESS THAN THE NUMBER OF OPTIONS YOU USED TO OWN.
Example: Assume you have 10 options with an exercise price of $8. And you decide to exercise those options when the stock is at $10. So you pay $80 to exercise those 10 options and receive stock worth $100, for a net gain of $20. Usually people will choose to “net settle” this transaction and simply receive $20.
To illustrate my point on Option Leverage, we’re going to assume you actually receive 2 shares of stock, which are worth $20. This helps us compare our old “option position” to our new “stock position”.
Here is Key Point: BEFORE the option exercise your investment position reflected 10 shares of stock vis-a-vis 10 stock options, but AFTER the option exercise your investment position only reflects 2 shares of stock. So now if the stock price goes up $1, what used to be a $10 gain for you is now only a $2 gain.
In short, the higher the stock price is relative to the exercise price the more value you can derive from your options. I’ve shown this concept graphically below. As a point of comparison, let’s consider you can either (a) hold the options (blue line) or (b) exercise them and trade them for shares of stock (red line and yellow lines).
The blue line in the graph shows the value of your options given a particular stock price. And the red line shows the value of those shares - given a particular stock price - if you had exercised your options at $10. The yellow line shows the value of the shares if you exercised at $20.
The blue line is higher than both lines, reflecting that the value of options is higher than both scenarios as long as the stock continues to appreciate. Below are the numbers reflected in the graph above.
So, if the stock appreciates to $50, your options would be worth $420 (blue line), but if you exercised at $10, and held onto those shares, then your shares and total return are only worth $100 (red line).
In summary, as long as you believe the stock is going to continue to appreciate, you should exercise your options as late as possible to maximize leverage.
Double Taxation(1)
I left taxes out of the examples above, because they complicate things and don’t add any value to illustrating the point. However, now we have to talk about taxes because they are the point.
Double taxation is the concept of being taxed at two points in time or twice. If you exercise stock you are taxed at ordinary income tax rate. And subsequently any appreciation in stock you may acquire is taxed at capital gains.
Tax event #1: Exercise options and pay tax on gain at ordinary income rate of 50%.
Tax event #2: Stock appreciates. Sell stock and pay taxes at capital gains of 30%.
You are better waiting to exercise the stock and only paying tax once at 50%.
Example: Imagine you have an investment worth $100 (i.e. your stock options). In Scenario 1, you sell it, pay tax of 50% and immediately reinvest (i.e. in stock). Then the investment doubles. You sell it and pay capital gains tax of 30%. OR, what if in Scenario 2, you hold it until it reaches $200 and sell it only once?
This is illustrated and perhaps more easily relatable when thinking about 401(k) plans. The value of a 401k is that it avoids double taxation. You pay taxes on earnings, invest the money and the appreciation of that investment does not get taxed.
The key point here, is that to avoid or minimize double taxation, you should hold your options as long as possible.
Option Leverage and Double Taxation
In the graph below we have combined the concepts of Option Leverage and Double Taxation, using the same example from above of 10 options with an exercise price of $8.
-The yellow and red areas represent “value lost” from option leverage and double taxation due to exercising too early.
-The blue line and area represents the value you realize if you exercise and hold the investment. The later you delay exercising, the more value you capture.
* If you exercise at $20, you receive $60 [((10 options * $20 stock price) - (10 options * $8 exercise price)) * (1 - 50% tax rate)]. Then your $60 is reinvested in 3 shares of stock ($60 / $20 per share), which grows to $50 per share. That investment is then worth $150 ($50 * 3), but the $90 of growth ($150 - $60) is taxed at capital gains of 30% or $27. So your net proceeds are $127 ($150 - $27).
Question: Why do we keep talking about exercise AND reinvest or hold?
Answer: In order to illustrate the value of holding an option over time, we have to compare it to something. An apples-to-apples comparison is a reinvestment in the same underlying stock.
Question: Shouldn’t I exercise and sell my options/stock and diversify or reinvest in a broader portfolio, say the S&P 500.
Answer: Perhaps. But consider that if you believe the underlying stock, i.e. your company’s stock, is going to perform similar to a broader market index like the S&P 500, then you are better off holding your options so you can capture Option Leverage and minimize Double Taxation.
Footnote:
(1) All the tax examples are super-simplified tax rates. The goal is to illustrate the concept so we assume a 50% combined federal and state tax rate for ordinary income and we assume investment income qualifies for capital gains treatment and that rate is assumed to be 30%. Both rates could be higher or lower based on individual circumstances.