By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.com
As common way to reduce risk and lock in gains, the early or premature exercise should be carefully considered, since there is a large potential tax bite and big opportunity cost in the form of forfeited time value, as we saw in risk of holding to expiration in Chapter 5. Here, the process of early exercise at a basic level is outlined and financial objectives and risks explained.
When an ESO is granted, it has a hypothetical value. In the case from the previous segment, this value was $35,000. This is pure time value, and it decays at a rate known as theta (the rate of time value decay, which is a square root function of time remaining). So the option is not worthless. If there were a listed option with 10 years to expiration, it too would have significant value. (For more on Theta, see Options Greeks: Theta Risk and Reward.)
Assume you hold ESOs unhedged worth, upon grant, about $35,000, using again our case from above. You may believe in the prospects for the company, and therefore you don't care about the stock price and your ESOs in the short run. Holding them until expiration is your simple plan, and if the stock price goes your way, you certainly may have gotten the most value from holding (although not necessarily given tax and time value loss considerations). But you might make nothing as well.
Value Composition for In, Out and At the Money ESO Option With Strike of $50 (Prices in Thousands)
Figure 8: A hypothetical ESO option with the right to buy 1,000 shares.The numbers have been rounded to nearest thousandth
Even if you began to gain intrinsic value with a price rise, you will be trading off extrinsic value along the way (although not proportionately). For example, taking an example of an in-the-money ESO with a strike/exercise price of $50 with the stock now at $75, there will be less time value and more intrinsic value, and more value overall. In Figure 8 (top set of bars), the red (intrinsic value) bar shows $25,000 in intrinsic but time value has dropped to $17,500 for the in-the-money-options.
The out-of-the-money options (bottom set of bars) show only pure time or extrinsic value, lower at $17,500 from those that are at the money (middle set), with a value of $35,000. The more an option is out of the money, the less value it has (just time value if out of the money). In other words, as options get more in the money and acquire more intrinsic value, they give up some time value, as shown in Figure 8. The intrinsic value is now value at risk. Therefore, many holders will look to lock in this gain (or part of it), and will give up any time value while incurring a heavy tax bite. That is the tradeoff.
The Value of Time
To avoid giving back intrinsic value "gain" on an ESO, holders will exercise early, known as a premature exercise, and acquire the stock at the strike price specified in the options agreement. Let's say it is $50 and the stock is trading at $75. The holder would like to lock in the $25 spread between the stock price and the exercise/strike price. By notifying the company that he or she would like to exercise the ESOs (let's say 1,000 shares), the company requires you to pay the price of the stock $50,000 plus withholding of $10,000 (40% x $25,000 gain on stock). Therefore, you must come up with $60,000 to do the exercise. Once you have the stock, you can immediately sell it, and take in the full value (after tax) of $15,000. But as we have seen above with the risks of holding ESOs, you have given up a big chunk of time value, which theoretically means you have made less than the after-tax gain of $15,000. The tax bite is big, as is the time value forfeiture. In fact, it's probably bigger than the actual after-tax gains.
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