Stock options are becoming more and more popular as the stock markets become increasingly volatile. Due to their mechanisms that allow investors to hope for higher returns on investment with limited downside risk, options are widely regarded as a safe investment choice. However, deciding when to exercise an option is a complex decision that requires a thorough knowledge of the factors that drive options trading.
In general, options give an individual the right to buy (call option) or sell (put option) an underlying asset by a certain date, called expiration or maturity date at a certain price, exercise or strike price. The right to exercise the option is not compulsory. The holder of the call option or the put option has the option to exercise the right of buying or selling the underlying asset by a certain date at a certain price, but if the right is not exercised by maturity date, the option simply expires.
To better understand how options work and when an option should be exercised we assume the following examples.
a) When to exercise a call option
We assume that an investor buys on October a call option on Microsoft at a strike price of $23.00. The price for an option to buy one share is $1. Therefore, the investor, who wants to buy American options, has to remit to the exchange $100 to obtain the right to buy 100 shares of Microsoft for $23.00 each. The other party, the seller of the shares, agrees to sell 100 shares of Microsoft for $23.00 each, if the investor decides to exercise the option.
Scenario 1: The price of Microsoft does not rise above $23.00 before October
In this case, the investor does not exercise the option and loses $100.
Scenario 2: The price of Microsoft rises to $35.00 before October
In this case, the investor buys 100 shares of Microsoft at $23.00 when their actual price is $35.00 and realizes a profit of $1,200 ($3,500-$2,300).
Conclusion: the factor that determines if the option will be exercised or not is if the share price will rise above strike price before maturity date.
b) When to exercise a put option
We assume that an investor buys on July a put option on Microsoft at a strike price of $20.00. The price for an option to sell one share is $0.70. Therefore, the investor, who wants to sell American options, has to remit to the exchange $70 to obtain the right to sell 100 shares of Microsoft for $20.00 each. The other party, the buyer of the shares, agrees to buy 100 shares of Microsoft for $20.00 each, if the investor decides to exercise the option.
Scenario 1: The price of Microsoft rises above $20.00 before July
In this case, the investor does not exercise the option and loses $70.
Scenario 2: The price of Microsoft falls at $15.00 before July
In this case, the investor buys 100 shares of Microsoft at $15.00 when their actual price is $20.00 and realizes a profit of $500 ($2,000-$1,500).
Conclusion: The factor that determines if the option will be exercised or not is if the share price will fall below strike price before maturity date.
Employee stock options
Often, organizations give their employees stock options, which provide them with a considerable source of deferred income. In general, employee stock options are not subject to taxation because holders do not actually receive any shares, but the option to buy or sell shares at a certain date in the future. Moreover, their post-exercised stock growth can be taxed as capital gains, which is advantageous for taxpayers who are in the top tax brackets.
The decision to exercise employee stock options is subject to numerous factors. In particular:
a) The estimated growth of an organization
If an organization is profitable and has the potential to be competitive over the next years, it is advisable not to exercise the options early. Important factors to be considered when evaluating the future growth of a company are the industry and the broader environment it operates; the industry trends; the growth opportunities; the market conditions; the sales performance in relation to competitors; the company’s fundamentals; the company’s leadership team.
b) Own financial needs
Employees who are in need for cash may consider exercising their options before reaching maturity. However, before taking such a decision, they need to compare the current stock value to the expected future value of the stock.
c) Portfolio rebalancing
Some people choose to exercise their stock options in order to diversify their portfolio. This strategy makes sense if the employee stock options hold a large percentage, at least 40%, in the portfolio asset allocation. Otherwise, by exercising the stock options, the risk is less likely to be reduced.
Overall, there are many strategies that can be implemented in regards to exercising employee stock options. However, in order to be successful and yield capital gains rather than income and avoid taxation, it requires careful thought and thorough consideration of all factors.