Savvy investors have a plan and stick to it. However, even positive events, such as receiving stock options from an employer, can disrupt their plans. Call options on a single stock are just not a part of most investors’ long-term investing approach. Here I investigate how incentive stock options fit with an index-based investing plan.
One simple answer would be to exercise the options (if they are in the money) at the earliest opportunity and sell the received stock. However, there are cases where this clearly makes no sense. For example, if you have 1000 options struck at $10, and the stock trades for $10.10, it makes no sense to cash out for only $100. Given the downside protection the options provide, it makes more sense to hold on. If the stock manages to get to $11, the value of the options increases 10-fold.
Another answer is to go on the open market and sell call options on your employer’s stock. On paper, this gives you both the stock value above the strike price plus the time value of the options. However, some incentive option agreements explicitly forbid this, particularly if the options aren’t vested yet. Another potential problem is that incentive option agreements often have clauses that permit the employer to revoke the options under certain circumstances; you could be left losing big money with naked calls.
So, I’m going to restrict the choices to either 1) continue to hold the options, or 2) exercise some or all of the options and sell the resulting stock. Under this restriction I will try to answer the question of when it makes financial sense to exercise and sell and when it makes sense to continue holding.
Determining how many options to hold requires making a number of assumptions. I treated the company stock as having the same expected return as the overall stock market, but with higher volatility. I did this by giving the stock the market return plus a random component. (For the math types, I used volatility figures from Meir Statman’s paper How Many Stocks Make a Diversified Portfolio? (standard deviation of 19.158% for the market and 49.236% for the individual company stock) and assumed the company stock return is the market return times an independent random variable with log-normal distribution to give the stock price the right total variance.)
The critical figures are
1. The strike price as a percentage of the company stock price.
2. The number of years before the option expires.
3. The value of the options (after exercise and stock sale) as a percentage of your total stock portfolio (including both stock index funds and stock options).
So, given the strike price percentage and remaining years on the option, we want to know the maximum percentage of your portfolio that should be made up of the stock options. To find this, I assumed that we want to maximize the expected compound return on combined stock index funds plus stock options.
Interpreting this chart
Let’s take an example to get a feel for what this chart means. Emily has a stock portfolio worth $100,000, including $20,000 in stock options (5000 options struck at $12 on shares that trade for $16). So, the strike price percentage is 75%. Looking this up in the chart, we see that the optimum option portfolio percentage is 12% to 13% depending on how many years are left on the options. If Emily believes the assumptions underlying this analysis, she should exercise about 2000 of her options, sell the resulting stock, and buy more stock index units with the proceeds.
Note that if the company shares rise in value, the strike price percentage drops at the same time as the percentage of your stock portfolio made up of options rises. So, in the happy situation where company shares are rising, we are moving left and up on the chart to where the optimum percentage value of options gets lower. This means that the rightmost part of the chart is largely academic. By the time we are considering exercising options, we have moved left along the chart.
There is no shortage of possible objections to this analysis:
1. Stock prices do not exactly follow a nice, tidy normal distribution; in the real world, black swan events are more likely than this.
2. Most people want to be more conservative than a strategy that maximizes expected compound returns.
3. You depend on your employer for your income, which creates a single point of failure to wipe out both your stock options and your income.
4. A given employer’s stock may be more or less volatile than the average individual stock. The kinds of companies that give out stock options to many of their employees tend to have more volatile share prices than average.
Most of these objections argue for being more conservative than the figures in the chart. However, there is one objection that argues for holding more stock options:
“My company is great. We’ve got a bunch of fantastic employees making the best products, and our stock is going to the moon.”
I’ve seen this way of thinking cause many people to hold onto valuable options until the stock drops to the point where the options are worthless. Optimism is good when you’re working hard at your business, but not when you’re investing your money.
We tend to be most optimistic about our company’s prospects when its stock price is rising. But this is exactly the time when the chart will tell us to exercise some options and sell the resulting stock. This is very hard to do when we’re optimistic that the stock will go even higher.
Nobody should blindly follow a chart like this. But without this chart, I really had little idea when I should exercise company stock options. My main takeaway is that the optimum percentage of my portfolio in company stock options is lower than I realized. I suspect that in most cases, people should be even more conservative than the chart suggests. However, it is likely that people will continue to take wild chances with their portfolios when they have valuable employee stock options.