Tuesday, January 31, 2012

When to Exercise Employee Incentive Stock Options

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.

Assumptions

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.

The results

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.

Objections

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.

Conclusion

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.

1. I think an important element to consider (and probably get expert counsel on) is the taxation treatment.

e.g. timing: if you don't exercise the option, you aren't taxed. It's conceivable that someone might take a calculated risk and choose to defer exercising an option (say waiting from Dec to Jan) in order to defer the taxation a year, if they believed that the stock would not be volatile in the interim...

Another scenario, specifically excluded above (but which you have previously covered in a different article pertaining to your own situation) is if a person exercises the option but does not sell the stock... This can have significant ramifications depending on what happens to the stock after exercise...

There are undoubtedly other scenarios which might arise.

2. @Nathan: You're right that taxation is an important consideration. However, it's very important to not use it to justify a wildly risky strategy. I doubt that it would make sense to delay exercise for tax reasons if your option holdings are more than double the percentage indicated in the chart.

Given my experience, I definitely don't recommend buying the stock and holding :-)

3. Michael,

Good story. Happy to see a good discussion on this topic.

1)"If the stock manages to get to \$11, the value of the options increases 10-fold."

Only the intrinsic value of the option increased by 10-fold. The theoretical value of the option itself may have hardly budged - especially if there are many years remaining before it expires.

2) It is not a good idea to exercise options with lots of time remaining. The time premium (value above intrinsic) can be substantial. The exerciser loses 100% of that time value.

Yet, it may seem obvious that the investor must sell (i.e., exercise and sell the shares) some of the options - just to reduce downside risk.

However, there are more efficient methods for reducing downside risk - rather than exercising options with considerable time value. One such choice is to buy puts. Another is to sell some stock short.

4. @Mark: The option agreements that I've entered into explicitly forbid buying puts on company stock or selling it short. As I explained in the post, these agreements prevented me from capturing time value in any way other than waiting. My analysis worked out when it makes sense to capture this time value by waiting and when it doesn't. The analysis would be quite different if more choices are available.

5. Michael,

I understand why you would not be able to short stock or sell calls. But not being able to own puts doesn't feel fair.

However, there's not much that can be done about that.

6. @Mark: Anything that smells like betting against the company is a problem. So, puts, writing calls, and shorting are all out. The reason behind this is that the options are supposed to be an incentive to stay with the company and work hard. If you can indirectly sell the options before they vest, or capture the time value before they expire, the incentive evaporates.

7. http://www.slideshare.net/OLAslideshare/answers-for-employee-stock-options-fiduciariesFebruary 5, 2012 at 6:19 AM

Mark is correct. It is very rare that companies have prohibitions against selling calls or buying puts while the employee holds employee stock options be they NQESOs or ISOs. However there are a few that do. I would bet however, that the writer, Mr. James can not name one major company that does.

And there are other advantages to selling calls and/or buying puts versus NQESOs and ISOs, one of which is the delay of taxes.

Those advisers who promote early exercises are doing the bidding of the company, which get major advantages in the form of recovering the forfeited "time value" and early cash flows from tax credits and the flow from the issuance and sale of new shares. And the advisers get assets under management which he uses to buy mutual funds or some other under performing assets.

The advisers promote the idea that early exercises, sale and "diversifying" is the best way to manage granted options. Those advisers are in violation of their fiduciary duties and violate SEC Rule 10b-5, in my view.

8. What relevance is there in whether I can name employers that forbid selling calls or buying puts on company stock? All my employers that have granted me options have forbidden such transactions, so I did an analysis based on such a restriction. If others have no such restriction, they can do a different analysis.

In your recommended strategies, how do you deal with the risk that incentive options might be forfeited for some reason leaving the employees holding naked calls?

9. I am forbidden also on calls, puts or shorts of any type. I have many options & RSU's that have been issued to me over the years & also participate in the employee purchase plan. My options get sold when the stock is favorably priced (+30% of option value) and/or they are nearing expiry. Since this is a taxable benefit and about 46% is withheld timing is everything to maximize my return on this "free" money. I choose to cash out and get a USD sent to me from the broker. I then re-invest in US based ETF's or direct stock purchase.

10. Interesting method!

Unfortunately, our SARs fell into your category of "more volatile share prices than average." In fact, for the first 3/4 of the time allowed to exercise they were underwater completely! Then as the final months began ticking down, they started to surge ahead, leaving us playing the "should I exercise now or wait one more day" game. We developed a strategy and stuck to it so that we wouldn't be too upset if the share price tanked again unexpectedly.

Fortunately, we've always considered options, SARs, RSUs etc as "phantom money." It's never been included in our asset allocation, net worth, or mental planning. So getting even \$1 is a bonus. That attitude has made it much easier when the stock involved is highly unpredictable.

I question the merit of using these types of "rewards" for employees in a volatile industry. But I know the company likes the fact they don't impact the DB pensions they have to pay out to some of the older employees, which may be part of their il/logic.

1. @Bet Crooks: Treating options and SARs like lottery tickets while they're under water is sensible, but once they move into the money, I don't think it makes sense to hold more of them than the chart indicates. You've got real money sitting there. I listed a number of arguments for holding fewer options than the chart indicates (such as the underlying stock being very volatile), but I know none for holding more. Thinking of any gains as found money or hoping for the underlying to rise are not good reasons to exceed a sensible risk/reward ratio.

I agree that stock options are not a good way to compensate employees, even CEOs. I wrote about that here:

http://www.michaeljamesonmoney.com/2008/07/alignment-of-interests-with-stock.html

11. I agree about not holding a higher percentage than the chart indicates. There was never any danger of that, though, because our real portfolio was so much greater than the value of our SARs that the chart says to keep 30% or less of the portfolio as options, and we were keeping less than 1%. We still wanted to get as many \$ for our SARs as we could, though.

1. @Bet Crooks: Sounds like your SARs are just barely in the money.