Stock options are powerful tools for building wealth. But they are completely different from common stock. First, they are leveraged instruments, meaning they can appreciate in value faster than common stock holdings--and they can also lose value faster. Second, they expire: Unlike stock, you can't hold options indefinitely; you have to decide when to exercise them. And third, determining their value requires some calculations, which we'll discuss below.
Further, there are different types of stock options, subject to different tax rules. The most prevalent today are non-qualified options, so we'll focus on those in our analysis. Incentive stock options used to be very popular, but are less so today. (See "What About Incentive Stock Options?" page 21.)
Given all these variables, stock options need to be carefully monitored and actively managed. Too many people who receive option grants simply hold them until they are near expiration, whether because they misunderstand their risk/reward characteristics, have no time to plan, feel peer pressure, or simply suffer from inertia. If you've been granted stock options, it is important to understand their fundamentals and create a plan for exercising them. Without a plan, you won't optimize their value and could even lose all their worth. With a plan, they can help you achieve your financial goals.
Managing options requires a basic knowledge of option pricing. (18) While the math of options can get very complicated, the basic concepts are relatively simple. The most important concept is that an option's total value consists of two parts: its intrinsic value and its time value.
Intrinsic value is the difference between the option's exercise price and the underlying stock's price. For example, if the exercise price is $10 and the stock price is $12, the option is "in the money" and its intrinsic value is $2. But if the exercise price is $10 and the stock price is $9, the option is "out of the money" and has no intrinsic value.
Time value is less obvious to many option holders. But a good way to think of it is this: Even if the option is out of the money, that doesn't mean it's worthless. You wouldn't hand it over to someone else for free, because the underlying stock still has time to appreciate. So an option has "time value," which is the option's value over and above its intrinsic value on any given day. An option's total value is the sum of its intrinsic value and its time value. (See "Understanding Time Value," page 19.)
But knowing your option's current total value isn't all you need to know to manage your options. The primary question you have to answer is: When is the optimal time to exercise?
Display 11 Comparing Option Exercise Strategies Expected Value of $100,000 Options (*) Award After 10 Years After Taxes and Inflation ($ Thousand)) Probability of Time value/Total 50% 5-10% Outcome Greater Than value 0 86% 90% 48 193 84% 80% 51 196 82% 70% 56 203 80% 60% 62 209 78% 50% 68 218 76% 40% 74 229 73% 30% 82 251 69% 20% 87 275 67% 15% 87 293 65% 10% 82 321 63% 5% 71 358 61% Expiration 35 450 (*) Assumes onetime S 100,000 pretax grant of options that vest over four years and expire in 10 years, and that exercised options are invested in 100% globally diversified equities. Values are net of income and capital gains taxes. See footnote 7, page 10, for global stock assumptions. The range of outcomes is based on Bernstein's long-term forecasts of capital markets. Data do not represent any past performance and are not a promise of actual future results or a range of future results. See Notes art Wealth Forecasting System, page 44, for further details. Source: Alliance Bernstein Note...