Contents

1. What Is a Stock Option?
2. Early Exercisable Stock Options: What You Need to Know | Cooley GO
3. 6 Strategies to Consider to Exercise Your Employee Stock Options

Exercising all your options in one year might bump you into a higher tax bracket. There may be benefits for exercising some options now and waiting to exercise others. It might make good tax sense to exercise a portion of your options annually rather than wait until the expiration date to exercise them all. Consider the volatility of your company's stock and the volatility of market conditions as a whole. Recessions can be ruthless on a company's operations and stock prices.

What Is a Stock Option?

Speculative market bubbles are increasing in frequency. Over the last 30 years, there have been two that have caused recessions.

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In the 90 years between and , there was only one that caused a recession—the crash of that led to the Great Depression. If your company is experiencing significant, rapid growth in an industry, you may want to consider exercising and reinvesting in less risky investments—especially if you begin wondering if a bubble is about to burst. On the other hand, if the company has weathered recessions before, you might consider waiting.

If yours is a financially sophisticated, high-net-worth household, you might pursue more advanced strategies than a family with less financial acumen.

A good rule to follow is that if you don't understand it, don't do it. John Olagues, the author of Getting Started In Employee Stock Options , talks about advanced employee stock option exercise strategies. He says that you can reduce risk and increase potential returns by using advanced strategies that involve selling calls and buying puts on the company stock. John is adamant that advanced option strategies are a more efficient way to reduce risk and capture the time value remaining in your options when compared to an exercise-and-sell strategy.

When considering your employer stock options, don't blindly follow a rule of thumb, investor advice or hold all options until the last possible moment. Consider all the factors to make a decision that fits your needs. Advantages And Disadvantages Early-exercise options with a repurchase right let employees who wish to make an early investment decision about the company start their capital gains holding period sooner. What Happens At Early Exercise At exercise, you have essentially purchased restricted stock with the same vesting schedule that applied to the stock options.

Alert: In this situation, you make a Section 83 b election even when you have paid the fair market value for the restricted stock and there is no discount or spread. You report that you have zero income for the value of the property received. Otherwise, you will owe ordinary income later on the stock's appreciation in value between purchase and vesting see the case Alves v. IRS Commissioner , decided in Alert: Should you forfeit the unvested shares, you cannot claim a tax loss for the amount of compensation income you paid tax on for your exercise.

Status Of Your Shares After Exercise The period for the company's repurchase right is similar to the cliff or graduated vesting schedules for traditional stock options.

Early Exercisable Stock Options: What You Need to Know | Cooley GO

Alert: You do not need to make this filing for standard stock options that you can exercise only after vesting. The stock you receive at the exercise of vested stock options is not subject to a substantial risk of forfeiture that triggers the ability and need to make a Section 83 b election.

Print this answer:. Share this answer:. We've updated our Privacy Policy, and this site uses cookies. Read the Privacy Policy to learn more. This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder.

Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days. Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer.

As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions. However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining. As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs.

With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock.

You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock. In addition to your ESOs, if you also have a significant amount of company stock in your employee stock ownership plan ESOP , you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA.

Understanding the interplay of these variables—especially volatility and time to expiration—is crucial for making informed decisions about the value of your ESOs. The first table below uses the Black-Scholes option pricing model to isolate the impact of time decay while keeping volatility constant, while the second illustrates the impact of higher volatility on option prices.

You can generate option prices yourself using this nifty options calculator at the CBOE website. As can be seen, the greater the time to expiration, the more the option is worth. Since we assume this is an at-the-money option, its entire value consists of time value. The first table demonstrates two fundamental options pricing principles:. This increase in volatility has a significant effect on option prices.

Similar results are obtained by changing the variables to levels that prevail at present. The key takeaway from this section is that merely because your ESOs have no intrinsic value, do not make the naive assumption that they are worthless. Because of their lengthy time to expiration compared to listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise. As discussed in the preceding section, your ESOs can have significant time value even if they have zero or little intrinsic value. In this section, we use the common year grant term to expiration to demonstrate the risk and reward associated with owning ESOs.

As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise.

In fact, your ESOs have the highest time value at grant assuming that volatility does not spike soon after you acquire the options. With such a large time value component—as demonstrated above—you actually have value that is at risk. This loss of time value should be factored in when computing your eventual return. Before we look at some of the issues surrounding early exercise—not holding ESOs until expiration—let's evaluate the outcome of holding ESOs until expiration in light of time value and tax costs.

Below shows after-tax, net of time value gains and losses at expiration. As a way to reduce risk and lock in gains, early or premature exercise of ESOs must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks.

When an ESO is granted, it has a hypothetical value that—because it is an at-the-money option—is pure time value. This time value decays at a rate known as theta, which is a square root function of time remaining.

6 Strategies to Consider to Exercise Your Employee Stock Options

You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way although not proportionately.

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The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim. As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value.

In fact for a deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value.