April 22, 2010

Deciding When To Exercise Stock Options

I work at a high tech company and like many tech companies my employer has granted me stock options over the years.   With the stock market crashing in 2008 many of my options have been worthless for some time.  But now that the market has recovered significantly I find my options are "above water" again.

One of the toughest things about stock options for myself and many others is deciding when to exercise them.  In the past I've simply held on to the options until they expired and then I would exercise them shortly before that or let them expire if they were worthless.   This hasn't been a very good strategy for me thus far.

Right now my options are worth about $12,000.   If I had cashed in my options several years ago I would have pocketed about $20,000 more than they are worth today.   But I got greedy or simply timed it poorly and I hung on to the options and rode the tide of the stock market until it crashed again.   Hindsight is 20/20 and I don't expect to sell at the exact perfect moment to maximize my profit.

I need to have a plan to exercise the options once the price hits certain levels and try and ensure a certain amount of gain.   If I don't have a plan to exercise then I may miss peaks in the stock value or I may be tempted to wait too long for the stock to go up in value. 

Figure out realistic expectations for what the stock value may be over time. 

If the stock is trading at $10 today then it is probably not very realistic to think it will be $20 in a year.  But its relatively realistic to think it will hit $10.50 or $11.00 within 12 months.   I shouldn't sit around waiting for the stock value to double but should instead set a target price that is more realistic and settle for that profit level.   One simple way to estimate future value is to project a 10% annual growth.  With a $10 price today that would look like this:

2010 = $10.00
2011 = $11.00
2012 = $12.10
2013 = $13.31

If you have 1000 options that are at a grant price of $9 and they expire in 2012 then its not unrealistic for the stock to hit $12 before the options expire.   The options would be worth $1,000 if you exercised them today and if the stock did hit $12 then you could cash in for $3,000.   Based on this kind of expectation of the future stock value I could set an order to exercise the options at $12 and settle for that.   If the stock hits $12 before they expire in 2012 then I'll profit $3000.  If the stock never hits $12 then I can always sell them for market value shortly before they expire.

Cash in Higher value options sooner

I've got some options at a higher price and some at a lower price.   Using the example of the stock value at $10, say you've got some shares at $8 and another option at $9.   If the stock goes up to $12 then your shares at $8 are worth $4 each and the shares at $9 are worth $3 each.   You might be inclined to cash in the $8 shares first since they are worth more.  Instead I would prefer to hang on to the $8 shares since they are going to be "above water" longer in case the stock value happens to go down again.  If you're at $12 then the stock can either go up or down or stay the same.   If the stock goes up then both your $8 and $9 shares are going to go up equally.  If the stock stays at $12 then theres no difference..   But if the stock goes down then you could potentially hit the point that the stock goes to $9 and the $9 shares are effectively worthless, however your $8 shares would still be worth $1 each.

Exercise shares that expire soonest first

I've got shares that expire in 2012 and some others that expire in 2013.  It makes sense generally to exercise the older shares that expire in 2012 first.   If I exercise the 2013 shares first then that leaves me with the 2012 shares and only 2 years timeframe for the stock to potentially go up.   If you instead exercise the 2012 shares first then you're left with the 2013 shares that will last 3 years.   Thats another year of potential growth of the stock that you could stand to profit from.

Bottom line:   The key strategy that I think I'll use for deciding when to exercise my stock options is to set a target price based on a reasonable expectation of the stock price and then exercise once I hit that price.

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