When to Exercise Your Options

Warning: Use this advice at your own risk. I am not a financial professional.

When I first received employee stock options, it was 1996 or so, and it looked like stock prices would just go up and up forever. Under that model, clearly no great strategy was required; one simply needed to wait until the last possible moment, and therefore the highest possible price, and exercise the options. Well, if you were going to have so ridiculously many that it would bump you up to the 39.6% tax bracket all of a sudden, maybe you’d want to unload some earlier to spread it out. It was a nice problem to imagine having.

Then came the dot com bust. Except for a few lucky souls at Google and the like, most of us no longer view our stock as something that will go up forever. For many, it has already come crashing down and only occasionally shows signs of growth. So how should you approach the problem of when to sell, now that your mind has sobered up?

I haven’t consulted any financial advisors on the topic, and for all I know I may be missing some very obvious theory on the subject. But here are the conclusions I’ve come to on my own, for what they’re worth.

Stocks are Volatile. You don’t know what’s going to happen tomorrow, or the next day, let alone in a month or a year. But it’s much more reasonable to suppose that a successful company with quality products is going to weather the storm and grow in the long term, than it is to believe that you know the stock is “low” or “high” today. For this discussion, it doesn’t matter so much – you’re stuck with your company’s options regardless of what the prospects are. The only way you’ll make money from them is if the stock goes up, so you might as well assume it will. But you can’t trust yourself to know when.

The principle of dollar cost averaging is a powerful way to minimize your risk of mispredicting, when you believe in the long-term prospects for a stock, mutual fund, or the market in general. Instead of trusting yourself to make timing decisions, you set up a regular fixed amount of money to make purchases on regular, predetermined dates. You buy often enough to overcome seasonal patterns; you don’t always want to be buying just before Christmas, in case that’s when the stock is always highest for some reason. Whether the stock goes up or down in a given period, you come out alright, as long as the stock goes up overall. When it was a bit high, you spent your $100 and bought fewer shares. When it was a bit low, you still spent $100 and thus bought more shares at that low price. Looking back after some years, most of your purchases should have been a pretty good deal, if the price has gone up like you thought.

So I decided to apply the same principle to exercising stock options. I have many sets of options, at different strike prices, expiring at different times. Many are underwater, or worthless, currently. I used to think I would be making hundreds of thousands off them. Now I’m more concerned that I don’t hold out too long and get nothing. But I still want to make sure I don’t miss out if they ever do go through the roof. I devised this scheme to balance those interests.

The Simple Version. Most of my options are exercisable for five years, starting five years after the date of issue. I decided that quarterly sales would be good for me. So that means there are 20 quarters over which I might want to sell each set of options. It makes some kind of sense then, to sell 5% of the options each quarter. However, I came up with this twist that puts dollar cost averaging into play. First, I look at the total exercisable value of all my options. Then I take 5% of that number, and that’s how much option profit I want to cash in this quarter. Now I’ve set my “fixed” amount of money for the quarter.

But which options do I exercise? I thought about it long enough to come up with what I now think is the provably correct answer: you sell the options with the lowest strike price first. This is because that allows you to sell the lowest number of options and still get the same amount of profit. That means you still have the most potential for growth.

You have to watch out that some options don’t expire unexercised. I haven’t run into this yet, but I might say, if after the above calculations you have any options that expire in less than a year, exercise a quarter of those options for each of the last four quarters. You could then decrease the number of low-strike-price options you sell. I’ll leave out this finer point in the following examples.

Suppose you have 100 options at strike price $10 and 100 options at strike price $20. Suppose you have just two periods to sell the stock, Now and Later.

Example 1. What if the stock is worth $15 Now and $25 Later? The aggressive position would say, wait until Later, and then sell all your shares. That would make you 100 * ($25 – $10) + 100 * ($25 – $20) = $2000 Later. The conservative position would say, sell everything you can now. That would make you 100 * ($15 – $10) = $500 Now, and then you would find yourself with more above-water options to be sold for 100 * ($25 – $20) = $500 Later, a total of $1000.

My approach would say, for Now, say I have $500 worth of value, and two periods to sell it in. So sell enough to make $250. That is, you would sell 50 of your lowest-priced $10 options. You would make 50 * ($15 – $10) = $250 Now. Later, you’d find yourself with 50 * ($25 – $10) + 100 * ($25 – $20) = $1250, for a total of $1500 profit. Notice how it came out between the aggressive and conservative positions?

Example 2. What if the stock is worth $25 Now and $15 Later? The aggressive position waits until Later and gets 100 * ($15 – 10) = $500, the second set being underwater. The conservative position sells it all up front for 100 * ($25 – $10) + 100 * ($25 – 20) = $2000. My approach says, Now I have $2000 of value, so I’ll sell enough to make $1000. The lowest price options are $10, worth $15 each, so I need to sell $1000 / 15 ~= 67 of them for $1005. Later, the second set is worthless but I can still sell 33 * ($15 – $10) = $165 for a total profit of $1170. Again we come out right about in the middle between aggressive and conservative.

Example 3. Suppose the options are worth something today, and remain somewhat volatile, but then crash at some point in the future, and stay underwater until they expire. The aggressive approach will have the options expiring worthless at the end. The averaging approach will still have some options expire worthless, but not all of them. It may even come out ahead of the conservative approach if some shares are sold at higher prices later on.

The Complex Version. Before I actually enacted the plan, I made it more complicated. Now I look at each set of options that are worth something, and I count how many quarters there are left where they will be exercisable. I divide the value by the number of quarters, giving me an average per-quarter value for that set of options. Then I add up all the average per-quarter values from all the sets of options. This is the total profit I want to take this quarter (use this instead of the 5% amount above).

You continue as before, selling the options with the lowest strike price first, until you come up with that total amount of profit. Again, make adjustments if you have options that are expiring soon, such as within a year.

When to Exercise. This is up to you, but the key is to pick the dates ahead of time and stick to them. Don’t gamble and think that you can guess when the stock is “high” or “low”. For example, if you have enough options to make it worth it, you could sell every month on the first Monday. Or a certain time every quarter, like I’m doing. You do need to be careful that you don’t pick dates that are going to be affected by some regular factor. For instance, if you always sell right after the earnings report comes out, you might be in trouble.

Summary. The basic idea here is that if you have options that are worth something, you make sure you actually take some of the profit on a regular basis. That way, if the stock crashes and all your options become worthless, at least you know you didn’t miss out on all the benefit by being greedy. On the other hand, you weren’t so conservative that you sold them all when they were worth $10,000 and missed the opportunity for them to be worth $100,000.

You can adjust this approach a little to be more conservative or more aggressive, based on your confidence in the long-term prospects of the stock. The 5% number above is based on selling quarterly, and always selling off equal proportions. If you have more confidence in the stock, you could sell 4% or 3% per quarter, preserving more options for the big potential gains later. If you have less confidence, use 6% or even 10%. The good thing about using percentages is you won’t sell all the options until the last quarter, whatever number you pick.

Exercising vs. Selling. It is of course possible to exercise your options without selling the stock shares. But I don’t see much point in that unless you’re an executive or something. People talk about the tax ramifications of exercising options, because indeed you have to pay income taxes on that profit. So some advise that you exercise earlier and hold the stock while it appreciates, to pay the lower capital gains rates. To me, that’s throwing away the whole value of the option. That is, with an (employee) option you’re not risking anything to have the potential to make more money. As soon as you turn that option into real stock, you have the potential for real losses. The only way that makes sense is if you were about to go buy a bunch of the stock anyway. Don’t worry about having to give Uncle Sam a bigger share — he’s only getting rich if you are, and you’re taking no risk doing it this way.

Warning: Use this advice at your own risk. I am not a financial professional. If I was, I probably wouldn’t be telling you this without charging you a fee.