Employee stock options investment thesis?

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imfocusedman
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Employee stock options investment thesis?

Post by imfocusedman » Wed Mar 06, 2019 7:41 pm

For those of you that are granted stock options through your employer (publicly traded), what’s the best way to exercise your options upon vesting to avoid market timing?

Specifically, I’m thinking about two different circumstances. The one where the options are “in the money” when they vest is more clear cut. But what about when they are underwater or alternatively worth more than $0, but maybe <10% of the grant value. When do you exercise those? Do you look at 3 or 6 month windows, do you wait for a certain $ value or something different?

Thank you.

skeptical
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Re: Employee stock options investment thesis?

Post by skeptical » Wed Mar 06, 2019 8:41 pm

I have seen many people hang on for the “run up"and lose a lot.

For typical options at a public company- sell and pay taxes as they vest, unless they are out of the money or not worth a lot, at that point, you lose nothing to little by waiting.

When to sell in the latter cases ? By definition, that is market timing. However, these cases typically mean that the company is not doing well, as options are typically granted at market value and start to vest at least a year from the grant, so you are now in the position to both time the market and time your company. Personally, I would wait until there is some run up and take what you can.

You may have atypical options.

KyleAAA
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Re: Employee stock options investment thesis?

Post by KyleAAA » Wed Mar 06, 2019 8:44 pm

Public companies still issue stock options? I thought pretty much everybody was on the RSU train these days. Except Netflix. Either way, the rule of thumb is to exercise as soon as you can and invest the proceeds elsewhere.

ChiActury
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Re: Employee stock options investment thesis?

Post by ChiActury » Wed Mar 06, 2019 10:26 pm

My strategy (may not be the right strategy) has always been:

If I need cash (ex. downpayment on a house), I exercise my options and sell the shares immediately to create enough cash to fund what I am trying to do.

If I don't need the cash, I exercise my options uniformly between the vest date and expiration date (and immediately sell the shares). Mine don't expire for 10 years, so exercise 1/10th per year. My rationale is:

A) Exercising all at once would not be tax efficient for me.
B) Options have higher leveraged upside. Example: If each of my options is 40 dollars into the money (say 60 dollar strike on 100 stock price), I could exercise, put the 40 dollars into a low-fee total market ETF, and ten years later have 79 dollars (=40*1.07^10). If my employer saw a 7% annualized return however, that same employee option would have been worth 137 dollars ( 100*1.07^10 - 60) after 10 years.

Obviously the downside of holding onto the option is that it may end up being worthless. But I have never counted any stock incentive money in my long term financial planning. I view it as gravy. If my employer does well, I'll retire at 55. If they don't, I'll retire at 65.

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Wed Mar 06, 2019 10:56 pm

Wouldn't make sense to sell as soon as RSU vest and purchase stocks of an uncorrelated company ?
The volatility is still there and so is the chance of hitting one out of the park, but if your company has troubles you don't lose your job AND your stock portfolio in one fell swoop.

As SAR, or other form of options are concerned, the best way is probably to calculate a Black-Scholes price and only exercise if time value is but a small fraction of total value. It requires assuming a value for their implied volatility, but maybe your company stock already has standardized options, or maybe you can use the current VIX level. Since usually these employee options have distant expiration dates also accounting for dividends takes some level of assumptions

Skiandswim
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Re: Employee stock options investment thesis?

Post by Skiandswim » Thu Mar 07, 2019 3:09 am

I include my options as part of a portfolio asset allocation. I treat the options as a concentrated investment risk within a diversified portfolio, and set a target allocation percentage (based on my risk tolerance). As noted, “in the money” options are more volatile than the underlining stock (strike price $10, market price $20, $2 price move is 10% for underlining stock, but 20% for option).

My thought process as to exercising options:
a) If my options are above target % in overall portfolio, I exercise back to allocation and reinvest proceeds in overall portfolio.
b) For non-qualified stock options, I have to pay payroll and regular income tax rates. I examine the possibility to exercise in a lower income tax year.
c) Employees can face voluntary or involuntary termination, which forces you to exercise options on a fixed date. I would rather proactively exercise based on an allocation model.

dcabler
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Re: Employee stock options investment thesis?

Post by dcabler » Thu Mar 07, 2019 7:21 am

KyleAAA wrote:
Wed Mar 06, 2019 8:44 pm
Public companies still issue stock options? I thought pretty much everybody was on the RSU train these days. Except Netflix. Either way, the rule of thumb is to exercise as soon as you can and invest the proceeds elsewhere.
A lot of companies do both now. Execs get options as a matter of course in my industry. But some times, non-execs also receive options under special circumstances.

+1 on the exercise/sell and invest the proceeds elsewhere - whether it's Options, RSUs or ESPP. It's not the most tax efficient thing to do, but a single stock can do absolutely anything in the year it takes to get to long term cap gains, especially in my industry. My view is that this is free money and I already have enough risk by simply working for the employer. I do likewise with any bonuses unless I need the money for a new car, house repair, etc.

MikeG62
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Re: Employee stock options investment thesis?

Post by MikeG62 » Thu Mar 07, 2019 8:43 am

imfocusedman wrote:
Wed Mar 06, 2019 7:41 pm
For those of you that are granted stock options through your employer (publicly traded), what’s the best way to exercise your options upon vesting to avoid market timing?

Specifically, I’m thinking about two different circumstances. The one where the options are “in the money” when they vest is more clear cut. But what about when they are underwater or alternatively worth more than $0, but maybe <10% of the grant value. When do you exercise those? Do you look at 3 or 6 month windows, do you wait for a certain $ value or something different?

Thank you.
I commented on this here (may be of some help):

viewtopic.php?f=10&t=216653&p=3333313&h ... K#p3333313

and here...

viewtopic.php?f=1&t=272993&p=4383249&hi ... n#p4383249
Last edited by MikeG62 on Thu Mar 07, 2019 10:26 am, edited 1 time in total.
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mhc
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Re: Employee stock options investment thesis?

Post by mhc » Thu Mar 07, 2019 10:08 am

Let's see if I can get this right. Options have intrinisic and extrinsic value. When you first get the option, everything is extrinisic value. The goal is to extract as much of the extrinsic value as possible. As the FMV goes up and time runs out, the extrinsic value goes down.

I receive 10 year options that vest 25% per year. Here is my "rules" for when to sell.
1. Less than 10% of the extrinsic value left
2. I need the money
3. Less than 20% of the extrinsic value left and less than 5 years left
4. I really want to exercise them by year 8
5. I try not to sell too many in a year so I don't get slaughtered by taxes

acegolfer
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Re: Employee stock options investment thesis?

Post by acegolfer » Thu Mar 07, 2019 10:48 am

Theoretically, the optimal time to "early" exercise an American call option (which applies to employee stock options) is when

exercise payoff (=S - K) > remaining option value

This may (but not always) happen right before the dividend payout date.

Jack FFR1846
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Re: Employee stock options investment thesis?

Post by Jack FFR1846 » Thu Mar 07, 2019 11:16 am

I've had options, RSUs and will add in ESPPs. With options, the moment they're in the money, they're sold and gone. Doing this once allowed me to pay off the mortgage, buy my wife a new car and still have leftover for taxes. A friend at the company held on, having seen the company more than 3 times the price I sold at. Stocks tanked. Friend left the company 5 years later with the options still under water. And yes, I've sold options when my net is all of $20. I do the same for ESPP and RSUs. Sell the milisecond I can, take the money and do what I want with it. Just sold RSUs and ESPPs in the last 15 days and my taxes were complete in that time, letting me know I could fill my and my wife's Roths for '18. So that's where $13k went to.
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Topic Author
imfocusedman
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Re: Employee stock options investment thesis?

Post by imfocusedman » Thu Mar 07, 2019 3:59 pm

Thanks all. Mike- helpful links. Appreciate that.

Surprised to hear some say “sell the moment they are in the money” by definition that would mean they will be worth $0.01. That’s different than “sell the moment that they vest, assuming they are in the money”, which I would have assumed was the right answer before reading your responses.

FootballFan5548
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Re: Employee stock options investment thesis?

Post by FootballFan5548 » Thu Mar 07, 2019 4:24 pm

I'd like to just play devils advocate for a moment. I realize this approach is very "un-boglehead".

I was 24, brought over to a publicly traded small "start up" type company. I left MegaCorp safety to come to this much smaller newer company. They paid more, but also threw options at me. First year's bonus, more options, 2nd year's bonus more options, 3rd year bonus more options, etc. etc. etc.

I've been here 11 years. In year 10, we got acquired. The original options were for roughly $25 per share. Our stock price ran up all the way to $140, split 3/1 (3x's the options now), and then we got acquired for $75 (post split, so 3x's the shares, now at 75 per share).

Clearly, this was incredibly incredibly lucky. But my company was and still is performing extremely well in our sector and since I was a younger guy, and treated the options as just some other form of compensation I didn't worry about, I never sold them/exercised them when they vested. I just sort of hung on to them.

Blindly exercising and selling options simply because Bogleheads says so isn't always the best thing to do. I'd treat them as separate from your AA and keep them out of your mind, and if you need them sell, if not just keep hanging on and hope for the best. There's definitely a bunch of added risk for your employment and options to be tied together... but there can be good outcomes I assure you if you trust your company and their direction.

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GoldStar
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Re: Employee stock options investment thesis?

Post by GoldStar » Thu Mar 07, 2019 4:34 pm

I have avoided market timing by cashing immediately. When I was young and foolish I would hold. At times I would sell half and hold half.

knowledge
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Re: Employee stock options investment thesis?

Post by knowledge » Fri Mar 08, 2019 1:46 pm

There is no overriding thesis, everyone's risk/reward meters are different. As mentioned above, to optimize stock options, you need to extract as much extrinsic value as possible. Generally, this means holding on to as long as you can before expiry. But we all know that the world doesn't work that way, and even options that are very much in the money can very quickly fall out of the money.

Over a 10-yr period at a company where I had options, the stock moved in a band that seemed bound, only to triple from the prior 8-year High (or 10x from the 8-year low). Whenever I discussed the company options, the emotions ranged from utter despair due to selling too early (who knew this would happen?) to sheer joy (who knew this would happen!).

There's no right answer, but do take the time to understand them and then come up with your plan.

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Fri Mar 08, 2019 1:53 pm

I don't think a vast majority of people, BH-ers amongst them, understand options.

mak1277
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Re: Employee stock options investment thesis?

Post by mak1277 » Fri Mar 08, 2019 2:09 pm

I think the materiality of the proceeds matters. If the gain upon exercise/sell isn't significant to me, I'm more likely to hold and hope for the value to grow. If the gain is significant, I'm more likely to sell immediately.

lvrpl
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Re: Employee stock options investment thesis?

Post by lvrpl » Fri Mar 08, 2019 2:23 pm

Thesaints wrote:
Fri Mar 08, 2019 1:53 pm
I don't think a vast majority of people, BH-ers amongst them, understand options.
Can you help us understand, then?

Tracker968
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Re: Employee stock options investment thesis?

Post by Tracker968 » Fri Mar 08, 2019 2:39 pm

I get the choice of RSUs or options each year. The options are managed by Fidelity and they will run an analysis for me. They use the Black-Scholes formula and recommend exercising at 95% of In-the-money value if you are very aggressive, 85% if moderately aggressive, 75 % if conservative.

Here is how they describe it:
"Options Analytics
It is often preferable to exercise options that are highly appreciated and closest to expiration. To quantify these concepts into a single
measure we use the Black-Scholes option pricing model. The Black-Scholes model calculates the theoretical value of stock options. It
specifies two principal components to the value of an option: (1) in-the-money value and (2) time value. In-the-money value refers to the
excess of the current market stock price over the exercise price of the option. Time value refers to the value of the option privilege itself."

I just exercised an option that was at 98% In -the-Money. It had about a year left. Within 2 weeks of exercising it the stock moved up $25 which would have increased my before tax gain by $16k. Oh well, that was the choice I made. I decided I would feel less bad about missing out on some gain than loosing an equal amount.

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Fri Mar 08, 2019 3:29 pm

lvrpl wrote:
Fri Mar 08, 2019 2:23 pm
Thesaints wrote:
Fri Mar 08, 2019 1:53 pm
I don't think a vast majority of people, BH-ers amongst them, understand options.
Can you help us understand, then?
Tracker968 just did. The key is estimating the option's time value, which depends on future dividends payouts and implied volatility. If there are traded standardized options in the same stock, one may try to extract that pricing information from market prices. If there aren't it is a matter of guesswork.

Since those employee options are non-marketable, one cannot just sell them and cash the residual time value. The choice is simply between exercise (and lose all of it) and hold.

mak1277
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Re: Employee stock options investment thesis?

Post by mak1277 » Fri Mar 08, 2019 4:01 pm

Thesaints wrote:
Fri Mar 08, 2019 3:29 pm
lvrpl wrote:
Fri Mar 08, 2019 2:23 pm
Thesaints wrote:
Fri Mar 08, 2019 1:53 pm
I don't think a vast majority of people, BH-ers amongst them, understand options.
Can you help us understand, then?
Tracker968 just did. The key is estimating the option's time value, which depends on future dividends payouts and implied volatility. If there are traded standardized options in the same stock, one may try to extract that pricing information from market prices. If there aren't it is a matter of guesswork.

Since those employee options are non-marketable, one cannot just sell them and cash the residual time value. The choice is simply between exercise (and lose all of it) and hold.
This doesn't change the fundamental discussion about choosing to diversify vs. holding value in a single stock though. At any given point in time, you can turn your option into a known amount of cash...do you want to keep that value in the option, or diversify it by buying an index fund?

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Fri Mar 08, 2019 4:05 pm

mak1277 wrote:
Fri Mar 08, 2019 4:01 pm
This doesn't change the fundamental discussion about choosing to diversify vs. holding value in a single stock though. At any given point in time, you can turn your option into a known amount of cash...do you want to keep that value in the option, or diversify it by buying an index fund?
The point is that the option's value can reside overwhelmingly in its time component. By exercising to diversify you would lose all of that and last time I checked 100k are always better than 50k, however undiversified the former might be.

This is particularly true for employee options that generally are issued with an expiration far longer than standardized options. Time value until they get close to expiration is generally most of their value.

mak1277
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Re: Employee stock options investment thesis?

Post by mak1277 » Fri Mar 08, 2019 4:13 pm

Thesaints wrote:
Fri Mar 08, 2019 4:05 pm
mak1277 wrote:
Fri Mar 08, 2019 4:01 pm
This doesn't change the fundamental discussion about choosing to diversify vs. holding value in a single stock though. At any given point in time, you can turn your option into a known amount of cash...do you want to keep that value in the option, or diversify it by buying an index fund?
The point is that the option's value can reside overwhelmingly in its time component. By exercising to diversify you would lose all of that and last time I checked 100k are always better than 50k, however undiversified the former might be.

This is particularly true for employee options that generally are issued with an expiration far longer than standardized options. Time value until they get close to expiration is generally most of their value.
But anything can appreciate. If I held a single stock it could outpace the index by 100%.

I accept the assertion that you get the majority of your option's value if you hold it longer. I don't accept the assertion that that gain in value over time is automatically better than being diversified...or more of a gain that you'd see if you invested in the index.

MittensMoney
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Re: Employee stock options investment thesis?

Post by MittensMoney » Fri Mar 08, 2019 4:38 pm

Thesaints wrote:
Fri Mar 08, 2019 4:05 pm
mak1277 wrote:
Fri Mar 08, 2019 4:01 pm
This doesn't change the fundamental discussion about choosing to diversify vs. holding value in a single stock though. At any given point in time, you can turn your option into a known amount of cash...do you want to keep that value in the option, or diversify it by buying an index fund?
The point is that the option's value can reside overwhelmingly in its time component. By exercising to diversify you would lose all of that and last time I checked 100k are always better than 50k, however undiversified the former might be.

This is particularly true for employee options that generally are issued with an expiration far longer than standardized options. Time value until they get close to expiration is generally most of their value.
99% sure that employee stock options as part of a compensation plan don't have Implied Volatility or Theta Decay. My ISO's certainly don't. If the company stock stays at $100 starting today until a year from today, my options would be worth exactly the same amount. Very different from options you're buying through your broker.

cwied
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Re: Employee stock options investment thesis?

Post by cwied » Fri Mar 08, 2019 5:25 pm

MittensMoney wrote:
Fri Mar 08, 2019 4:38 pm
99% sure that employee stock options as part of a compensation plan don't have Implied Volatility or Theta Decay. My ISO's certainly don't. If the company stock stays at $100 starting today until a year from today, my options would be worth exactly the same amount. Very different from options you're buying through your broker.
Here's a thought experiment: if you had an employee option in a company that you know is going to be valued at $100 from today until the expiration of the option, would you trade it for an option in a company that is $100 today but might go to $1000? Even though there is no secondary market for the option, there certainly is a value in the volatility that would diminish the closer you get to expiration. It's just that you can't realize that value by selling the option.

acegolfer
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Re: Employee stock options investment thesis?

Post by acegolfer » Fri Mar 08, 2019 5:50 pm

MittensMoney wrote:
Fri Mar 08, 2019 4:38 pm
99% sure that employee stock options as part of a compensation plan don't have Implied Volatility or Theta Decay. My ISO's certainly don't. If the company stock stays at $100 starting today until a year from today, my options would be worth exactly the same amount. Very different from options you're buying through your broker.
option value = intrinsic value + time value.

In your example, the intrinsic value ($100 - K) is the same between 2 time periods. But the time value decreased over 1 year (it converges to $0 at expiration). Overall, your options are worth less after a year.

If one knows binomial option pricing model, calculating the value of employee stock option is not too hard. If the company is listed, it's really easy because we can find the implied volatility.

Topic Author
imfocusedman
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Re: Employee stock options investment thesis?

Post by imfocusedman » Fri Mar 08, 2019 8:33 pm

Would be curious to see that equation. Sounds like the revised answer is to hold 10 year options for 9 years and 364 days if you can stomach it. Thanks for all the input. Will have some fun with this one.

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Fri Mar 08, 2019 9:38 pm

mak1277 wrote:
Fri Mar 08, 2019 4:13 pm
I accept the assertion that you get the majority of your option's value if you hold it longer. I don't accept the assertion that that gain in value over time is automatically better than being diversified...or more of a gain that you'd see if you invested in the index.
Absolutely. If at some point the time value has become 1% (or any other small figure you pick) of the total value, rather than wait to cash it in, you may want to exercise and move to the S&P 500.

MittensMoney
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Re: Employee stock options investment thesis?

Post by MittensMoney » Thu Mar 14, 2019 4:18 pm

But the time value decreased over 1 year (it converges to $0 at expiration).
But my ISO's don't have an expiration date.

Thesaints
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Re: Employee stock options investment thesis?

Post by Thesaints » Thu Mar 14, 2019 5:17 pm

MittensMoney wrote:
Thu Mar 14, 2019 4:18 pm
But the time value decreased over 1 year (it converges to $0 at expiration).
But my ISO's don't have an expiration date.
If your options never expire they have an infinite value regardless of their strike price and the underlying stock volatility !!
At least, from a strictly mathematical point of view.
Then we have to consider that you can't cash in their time value and that you (knock on wood) are going to expire much earlier.
Do your options transfer to your estate, or do they vanish at that point ?

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