5 Factors Help You Decide When to Exercise Stock Options
Your individual circumstances will determine when the time is right
Some articles say you should hold onto your employee stock options as long as possible. Don't exercise them until they're near their expiration dates. In theory, at least, this gives the stock an opportunity for additional price appreciation.
But this may not always be the right advice. Your circumstances, your comfort level with risk, your tax situation, and a few other factors should also be considered.
Your Financial Needs
If you're holding the options in the hope that the stock price will climb higher, consider your current needs for cash compared to the potential of additional gains. If you need cash now and your options have value, exercising now is a sure thing. A higher stock price in the future is not certain.
You might want to exercise early because:
- You have high interest rate debt that you could pay off.
- You do not have adequate cash savings and you need a larger rainy day fund or emergency fund.
- You need funds for a down payment on a house.
- You have another compelling investment opportunity that you think has more potential than the company stock.
- You need tuition funds for a child in college.
The Risk/Return Tradeoff
There's a component to your employee stock options called time value. When there are many years left until the expiration date, time value is the potential for additional future gains.
Along with time value comes the risk that the stock might go down. The gains you would realize by exercising today would disappear.
You might want to take risk off the table and forego potential additional gains if:
- A fairly significant amount of your financial wealth—more than 10 percent—is already tied up in company stock.
- Cash in hand today could provide a significant improvement to your financial situation based on your financial needs.
- You don't think the prospects for the company stock look attractive.
Tax planning involves projecting your expected income and deductions over the upcoming years. Exercising all your options in one year could bump you into a higher tax bracket. There may be tax reasons to exercise some options now and wait until later to exercise others. It might make sense to exercise a portion of your options every year rather than wait until the expiration date to exercise them all.
The volatility of your company stock and the volatility of market conditions as a whole should be considered. The sun doesn’t always shine. This point is well made in CNN Money’s article on exercising stock options:
“During the tech stock bubble, for example, at least a few conservative employees took profits in their high-flying companies' shares. Turning paper gains in options into real cash—despite exercising "early" according to conventional wisdom—seems to have been extraordinarily prudent in retrospect.”
Quantity of Options/Investor Sophistication
If yours is a sophisticated, high-net-worth household, you might pursue more advanced strategies than someone with less sophistication.
A good rule to follow is that if you don't understand it, don't do it. John Olagues, author of Getting Started in Employee Stock Options, talks about advanced employee stock option exercise strategies. John is a former Stock Options Market Maker from the Chicago Board Options Exchange and the Pacific Options Exchange in San Francisco.
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 when compared to an exercise- and-sell strategy, advanced option strategies are a more efficient way to reduce risk and capture the time value remaining in your options. John outlines his thoughts in 5 Golden Rules for Managing Employee Stock Options. Keep in mind that these advanced strategies are best implemented by those with employee stock options that are potentially worth $500,000 or more.
Don't blindly follow a rule of thumb and hold all options until the end. Consider all factors to make a decision that fits your needs.