By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.com
When you hold ESOs, as an employee you will have certain risks at all times, contrary to what you might believe or be told. Recall from previous chapters of this tutorial that you hold options with an expected time to expiration, therefore, your ESOs can have significant time value even if out of the money (i.e. under water). It would depend on how far under water and how much time remaining to expiration. (What's your risk tolerance level? Find out in Risk Tolerance Only Tells Half The Story.)
The Risks of Owning ESOs
We will work with the common 10-year ESO grant term to expiration. As soon as you receive the grant from your employer, you typically would have no intrinsic risk because the option is granted at the price of the stock, usually at the close of trading the day of the grant.
Therefore, your exercise strike, or strike price, is equal to the close price on the day of the grant and your ESOs are at the money from the start. Many believe they have no value since you cannot sell them and can only reap a profit from the stock price getting above the strike price, or getting in the money. Once that occurs, intrinsic value appears and you can easily determine their value (intrinsic). But the mistake is not realizing that there is time value on the option, as well, even on the grant day. And that represents a large opportunity cost if you are prematurely exercising.
In fact, upon grant, your ESOs will have the highest time value (assuming volatilities don't jump soon after acquiring the options). So with such a large time value component, you actually have value, and thus you have value at risk. Most traditional ESO planning ignores this value at risk, which is unfortunate. Remember, time value, not just intrinsic value, is your compensation, so losing time value is like bleeding away part of your pay. Your ESO is valued by your employer on grant day for expense purposes, so time value is being counted on its balance sheets. For reference's sake, you should be doing the same. After receiving an ESO grant from your employer, it is important for you to understand how to plan the management of your potential risks and rewards while holding the options, including time value at risk. (To learn more, see The Importance Of Time Value.)
Holding Until Expiration
As you can see in Figure 6 (below), the potential gain and loss from holding an ESO with strike of $50 to expiration (assuming a 60% volatility level and 10 years to expiration), is rather grim. If the stock is exactly where it was on grant day, you lose $35,000 in time value. You are left with nothing. You have gambled, in effect, on a stock price rise that did not occur. Think of how often companies' shares go down - not up - in value.
If you are lucky enough to have the stock price at $110 by expiration, you would have $60,000 in value on the ESOs ($110,000 - $50,000 = $60,000 spread gain). However, you bled away the $35,000 in time value by holding it to expiration, leaving a net "gain" of just $25,000 pretax. Once you factor in the ordinary income tax applied to "gains" from exercising (applied to the $60,000, not $25,000), you are left with $36,000 (40% x $60,000 = $24,000 in compensation tax paid at exercise to employer). If you deduct lost time value, you are left with net after tax gain of just $1,000 in gains ($36,000 - $35,000 = $1,000).
What is not understood well by ESO holders is the bleeding of time value, which is in reality a loss, but not tax deductible. While there are ways to hedge the time value and capture it as potential income, very few financial planners or wealth managers have the experience to go down that road. When this is properly done, however, it is possible to take cash out of your ESOs through selling listed calls, a subject that is beyond the scope of this tutorial.
Figure 6: ESO P&L with $50 strike and 10 years to expiration upon grant. Numbers have been rounded to nearest thousand.
Figure 7: ESO representing 1,000 shares of stock and having an exercise price of $50 and fair value of $35,000 with 10 years to expiration.
Before looking at some of the issues surrounding not holding to expiration, let's take a look at the outcome of a hold until expiration in light of the time value and tax costs. If you just hold your position to expiration and then exercise, in Figure 7 you can see a schedule of after-tax, net time-value expiration gains and losses. The plot of values shows that at a price of 120 upon expiration, the actual gains are just $7,000. Gross gains are $70,000 (the value of the options at expiration). However, $35,000 in time value was bled away during the 10-year period assumed here, and $28,000 in compensation taxes were paid on the gross "gain" of $70,000 upon exercise. Take out $35,000 in time value and you are left with $7,000 in net gains. Note that breakeven price is at $109 for the stock price when you include the time value loss in the equation, as seen in Figure 7.
When an exercise is requested, the ESO holder must pay the strike price ($50 in this case for the stock, or $50,000 plus the $28,000 in taxes, or $78,000) even if the stock is not sold. If the stock is liquidated as part of the exercise, he or she would receive $120,000 in stock. When we subtract $78,000 (purchase and tax), the balance is $42,000. But the options had initial value of $35,000, which was lost by holding to expiration, leaving a net gain of $7,000.
Selling to Cover
It is possible to do a "sell to cover" exercise notification, which may be possible with some employers, allowing you to sell enough shares of stock to pay the exercise price and taxes upon exercise. Finally, if you take out the time value aspect to the ESO, the net gain is $42,000, which is what most look at when considering the question of exercise. But it must be stressed that the time value is a real value that is lost in the process. Any self-respecting trader of listed options would be laughed out of the business if he or she ignored the lost value known as time value.
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