5 Factors To Use in Deciding When to Exercise Stock Options

Your individual circumstances will help determine when the time is right for you

Couple looking at exercising stock options.
Use these 5 factors to find the best time to exercise your stock options. Jamie Grill

Some online advice articles say you should hold your employee stock options as long as possible and not exercise them until they are near the expiration date, thus giving the stock the opportunity for additional price appreciation. I do not think this is always the right advice. Your circumstances, comfort level with risk, tax situation and a few other factors should also be considered.

Here are five factors to use to come up with a personalized answer as to the best time to exercise your employee stock options.

1. Your financial needs

Consider your current needs for cash compared to the potential of additional gains if you hold the options in hopes the stock price will climb higher. 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.

A few reasons you might exercise early would be:

  • You have high interest rate debt that could be paid off.
  • You do not have adequate cash savings (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. A real estate purchase, for example.
  • Your need tuition funds for a child in college.

2. The risk/return tradeoff

There is a component to your employee stock options called time value. If 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 goes down, and the gains you would realize by exercising today disappear.

You may wish to take risk off the table, and forego potential additional gains if:

  • A large amount of your financial wealth is already tied up in company stock (greater than 10%).
  • Cash in hand today could provide a significant improvement to your financial situation based on your financial needs.
  • You do not think the prospects for the company stock look attractive.

3. Tax planning opportunities

With tax planning you project out 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 some later. For tax reasons, it may make sense to exercise a portion of your options every year rather than waiting until the expiration date to exercise them all.

4. Market conditions

The volatility of your company stock, and market conditions as a whole need to be considered. The sun doesn’t always shine. This point is well made in CNNMoney’s article on exercising stock options where they say,

“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.”

5. Quantity of options/investor sophistication

If you are a sophisticated, high net worth household you may pursue more advanced strategies than someone with less sophistication.

A good rule to follow - if you don't understand it, don't do it. I spoke with John Olagues, author of Getting Started in Employee Stock Options in regards to 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 has applied his knowledge of hedging and trading strategies to employee stock options, and says you can reduce risk and increase potential returns by using advanced strategies, which 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 of reducing risk and capturing the time value remaining in your options. John outlines his thoughts in 5 Golden Rules for Managing Employee Stock Options.

These advanced strategies are best implemented for 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 the factors above to make a decisions that fits your needs.