Stock options can be a stressful experience. It’s common for clients to agonize over the price at which they exercise, fearing it may go higher. Alternatively, some clients have many option grants and fear financial ruin if the stock collapses. The key to managing this anxiety is to adopt a framework that balances the risks and rewards of continuing to hold each option. The goal is not necessarily to maximize the value – it’s to exercise at a point when the risk outweighs the potential reward, and re-invest the proceeds in a diversified portfolio.
The value of an option is split into two distinct components: intrinsic value and time value. Intrinsic value is readily observable in the market – it’s the difference between the current stock price and the grant price of a particular option. Time value is not readily observable in the market, but is a function of the time remaining until expiration, the volatility of a stock, and general interest rates.
The Black-Scholes formula has been used for decades in the financial industry to estimate the value of option contracts. By rearranging the equation, we isolate the intrinsic and time value for each particular option grant.
The “Truepoint Ratio” is a threshold we use internally as a decision-making framework for when it’s time to exercise an option. It expresses how much of an option’s theoretical value has been realized.
When this ratio is high, most of the option’s value has been realized. At this point, investors have much to lose and less to gain from continuing to hold the option.
Aren’t There Other Considerations?
Every individual should consider options in the context of their unique cash flow needs, the tax impact of exercising the options, and the overall impact to their financial plan. At Truepoint, we take an integrated approach to stock options – combining each specialty area (tax, investments, and financial planning) into a unique recommendation for each of our clients.