The first rule of managing your employee stock options is to avoid premature exercises. Why? Because it forfeits the remaining "time premium" back to your employer and incurs an early compensation income tax to you, the employee.
When employee stock options are granted, the entire value consists of "time premium" because there generally is no intrinsic value at the grant date since the exercise price is generally the market price on the day of the grant.
What Is Time Premium?
This time premium is a real value and not an illusion. The time premium is what the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) require all the companies to value at the grant date and expense against their earnings over the option's vesting period. The maximum contractual time to expiration is 10 years but evaluators use what is called the expected time to expiration as an input assumption into theoretical pricing models such as the Black Scholes model.
When a grantee receives an employee stock options grant, he receives a value and the employer takes on a contractual liability to perform in respect of the grantee's contract. The value of the company's liability should be equal to the value of the benefit to the employee. Some pundits speculate that the cost to the employer is greater than the real and perceived benefit to the employee/grantee. This may be the case when options are misunderstood by the employee/grantee. But in most cases, the values that companies expense are actually understated, with the value to informed grantees being greater than the assumed liability costs to the company. (For more insight, read our Employee Stock Option Tutorial.)
If the stock moves up and is in-the-money, then there is now an intrinsic value. But, there is also still a time premium; it doesn't just disappear. Often the time premium is greater than the intrinsic value, especially with highly volatile stocks, even if there is substantial intrinsic value.
When a grantee exercises ESOs prior to expiration day, he gets penalized in two ways. First, he forfeits all of the remaining time premium, which essentially goes to the company. He then receives only the intrinsic value minus a compensation, tax which includes state and federal tax and Social Security charges. This total tax may be more than 50% in places like California, where many of the options grants take place. (These plans can be lucrative for employees - if they know how to avoid unnecessary taxes. Check out Get The Most Out Of Employee Stock Options.)
Figure 1: Results of premature exercise and sale of stock
Source: "How Professional Market Makers Would Manage Employee Stock Options." By John Olagues and Ray Wollney.
Assume for a moment that the exercise price is 20, the stock is trading at 40, and there are 4.5 years of expected life to expiration. Assume also that the volatility is .60 and the interest rate is 3% with the company paying no dividend. The time premium would be $6,460. (Had the assumed volatility been lower, the amount forfeited would be lower.) The $6,460 would be forfeited back to the company in the form of a reduced liability to the grantee.
Options advisors or wealth managers often advocate forfeiting the time premium and paying the tax by premature exercises in order to use the money to diversify (as if a diversified portfolio is some sort of magic bullet). They essentially advocate that you return a large part of your compensation to the employer and pay an early tax for the privilege of diversifying into a fund loaded with fees and commissions, which underperforms the indices. Some claim that the reason advisors advise and the companies endorse the idea of making early exercises is because it is highly beneficial to the company in the form of early tax credits and reduced liabilities. That could certainly be the reason that early exercises are the predominant method that employees use to manage their options.
The Bottom Line
Stay away from premature exercises and hedge your positions by selling calls and buying puts. You will end up with a lot more money if you do. (Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of a stock in Accounting and Valuing Employee Stock Options.)