Copper Beech Advisors Blog

Understanding Executive Stock Options - Part I Stock Price

Posted by Timothy Caban on Jun 16, 2015 11:41:00 AM

A Shiny New Car?

How do you decide when to sell your executive stock options?  When it's time to buy a new car?  When the college bill comes due? How can you be sure that you're getting the most out of these key pieces of your compensation?20150612_Hockey_Stick_Clip_Art_Free

If you are a successful executive at a large corporation, there is a good chance that you have received some employee stock options and/or some restricted stock as part of your compensation.  You are then confronted with having to decide when to exercise your stock options.  To make a great decision, you should actually consider a minimum of three factors.  In this post, I'll describe all three factors and then focus on one, stock price, in a little more detail.

Three Key Factors

  1. Stock Price
  2. Taxes
  3. Cash Flow - Your Life

There are quite a few things to consider when deciding when to sell your stock options, including whether you think the stock price will go up or down, what will happen to your tax bill with the complexities of the tax code and things like the AMT, and what does the rest of your financial life look like?  Do you have enough cash for a rainy day or is your savings account lower than you would like?  These are all things you should consider.

For this post, I'm going to concentrate on the first factor: Stock Price. 

You may be wondering why there is a picture of a hockey stick accompanying this post.  Actually, a hockey stick is a great way to illustrate the possible results that you might experience when you hold stock options.  Stock options are different from stock in one important way. 

With a stock, your shares increase in value as the stock price goes up and decrease in value when the stock price goes down.  The value of the shares won't go to zero unless the company goes bankrupt, which is a pretty rare case.  Think Enron.

Not so with stock options.  When you receive stock options, they come with something called a strike price. This is where you can "buy" shares of your company stock.  For example, you might have 100 options with a strike price of $20.00.  If the company stock trades below $20.00 then your options are worth nothing.  Your company isn't worth nothing but your options are.

Back to the hockey stick.  If you think of the blade of the stick as $20, then the handle of the stick is what happens to your options as your company stock price rises above $20.  In theory, the price can go up forever. Have you held stock options over the last few years?  The stock market has resembled the handle of the hockey stick.  When did you exercise your stock options?  Are you still holding them?  When do you plan to sell?

The most reliable way to decide when to sell is to use something called the Insight Ratio®.  It is a mathematical way to use both the actual stock price and the time remaining until the options expire, to make a decision about when you want to sell.  Another way to think of the Insight Ratio® is that it is the theoretical value of your stock options.

If you think of the theoretical value as 100% of what the options might be worth, you want to do your best to capture as much of that 100% as possible before you decide to exercise your options and sell your stock. As the market goes up, you capture more of this value.  As time elapses, you capture more of this value.

Establishing a disciplined way to know when to exercise your stock based on the strike price is one of the keys to making great decisons with your stock options.  However, it is only one leg of a three legged stool.  Taxes and Cash Flow are equally important factors.  I'll cover those in future posts.





Topics: Stock Options, Investments, Stock Price