1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Premature Exercise Risks
  8. Employee Stock Options: Conclusion

By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.com

The biggest difference between listed options and ESOs is that ESOs are not traded. This is the difference that keeps academics publishing articles about how to put a fair value on these assets. In other words, they have no quoted value, unlike other options trading in the world's largest exchanges. All reference prices, therefore, arise from theoretical pricing models, like Black-Scholes, except at expiration when the value is the amount the ESO is in the money (price above strike).

We saw in the previous chapter that this can lead to "invisible" pricing – if the options are out of the money (stock price is below strike price) - when the value is pure time value and only viewable with a pricing model. Most ESO holders with little experience in options trading might mistake this to mean their options have no value. But this is an unfortunate misunderstanding, especially if the options have a little intrinsic value and they attempt to capture that with an early or premature exercise. Unaware of the lost time value in an exercise, you are unknowingly being penny wise and pound foolish. In the early life of your ESO,you will have a significant time value component that is lost upon exercise, so you should value your ESOs properly before making any financial decisions about exercise to capture intrinsic value.

The Value of Your ESO
Without a market price reference point, it is difficult to "see" the value. Since many ESOs are granted with 10 years in life, you don't have listed options trading with an equal amount of time on them for making a comparison either. LEAPS equity options (listed long-dated options), have expiration dates as far as two years out in time, but this will only help if your ESOs have two years or less in time remaining. In other words, there is a big gap between two and 10 years that leaves you without market price reference points (and these market prices may not be the best proxy prices anyway). Models, therefore, are necessary and your employer is required on the grant date to specify a theoretical price on their balance sheet and in your options agreement. Be sure to request this information and how they determined the value of your ESO.

Unlike listed options, furthermore, the time to expiration input in theoretical pricing models may be shortened, or discounted, based on employer determined assumptions about expected length of employment and expected time holding before exercise. This will lower the theoretical value of your ESOs. Assumptions about volatility can do the same thing if the company makes lower than normal levels of volatility assumptions, especially when combined with discounted time to expiration, so be careful which model you are getting your theoretical values from.

It is a good idea to get several estimates from other models to compare to your company's valuation. The lower the value of either time to expiration or volatility, the lower will be your stated theoretical value. When hedging is factored into the equation, the assumptions used by employers can be completely erroneous and hedging itself may actually add theoretical value.

Any partial hedging of your ESOs may mean that you hold your options longer, even all the way to term, so hedging has an added benefit in allowing you to hold longer, thus raising the theoretical value. Of course, hedging may allow you to capture most of the time value that is lost typically by most ESO holders looking only at the intrinsic value capture end game.

Listed Options Specifications
Listed, or exchange traded stock options, are standardized so all terms are alike whether you are trading IBM or Microsoft or any other company's stock options. The specifications are easier to understand. If you own a call option, for instance, you have the right to buy 100 shares of stock at a specified price (strike price) for a limited amount of time (the time remaining until expiration of that listed option). If you hold a put option, it gives you the right to sell 100 shares at the strike price until the put option expires. The time remaining depends on the expiration month of the option. While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. There are no actual options with standardized multipliers of 100, as with listed options.

Last Day of Trading – Expiration
For all listed stock options in the U.S., the last day of trading is the third Friday of the calendar month of the option contract. At the close of trading on that Friday, the options no longer trade and are automatically exercised if more than .01 in the money. If exercised, you will receive either a short stock position (if you owned the put) or a long stock position (if you owned the call). If you had 100 shares of long stock to begin with, instead of 100 shares long stock position, you would now have 200 because the automatic exercise would get you additional shares. If you had the 100 shares and owned a put, you would get 100 short shares that would offset your 100 long shares, leaving you flat. (Learn more about the expiration process in Stock Option Expiration Cycles.)

Much of this carries over to ESOs, except that ESOs are not granted in number of options but shares you have the right to buy. They are granted with a number of shares represented by the grant. That is, you are granted ESOs with the "right to purchase 1,000 shares of XYZ stock." Therefore, if you held these until expiration (10 years in most cases), you would notify your employer to exercise your ESOs upon expiration, but you should consult your stock plan and options agreement for more details about the specific requirements as they may differ company to company. You must notify your intent to exercise before expiration if you would like to acquire 1,000 shares long or you will forfeit that right. Unlike listed options, which are automatically exercised if in the money by more than .01 at expiration, ESOs are not automatically exercised.

Strike Prices
Since listed options have standardized strike prices, trading in increments of $2.50, $5 and $10, depending on the price of the underlying security (generally, higher prices trade with higher increments), there is no confusion about strikes. However, with ESOs, since the strike price is usually set by the market, you could have any strike price. On the grant date, the strike typically would be the market close price, which means there are no standardized strikes, only randomly set prices determined by what the closing prices happen to be. However, the company may back-date options, as occurred in many abuse cases, setting a more favorable date for determining the strike, such as one that makes the strike lower than the market price upon grant, thus creating an instant "profit" for the holders.

Acquired Stock Restrictions
With listed call options, when you exercise and get the stock you can dispose of it as early as markets begin trading again in that stock. However, with acquired stock through an exercise of your ESOs, you may not be able to sell your stock. Even if your ESOs have vested (so now you can exercise them), the stock you acquire may not be vested. This restriction will prevent you from liquidating the stock for a period of time that can expose you to risk of the loss on your stock position, and after having paid income tax on the exercise spread value. If you are not hedging, then you face a double dilemma.

When you exercise an ESO, if there is intrinsic value, you are taxed at ordinary rates on what is deemed compensation income, due in the tax year of the exercise. Meanwhile, if you are restricted from selling your stock immediately, you can lose money on this position and, while this would result in capital loss for that tax year, you can only apply up to $3,000 per year as a write-off against income. Therefore, you may not be able to offset ordinary income tax liability resulting from the exercise for many years due to the limited annual offset allowed on capital losses. Hedging with listed options, however, opens up some great opportunities to better manage tax liabilities both before and after exercise, a topic beyond the scope of this tutorial.

Employee Stock Options: Valuation and Pricing Issues
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