No Crystal Ball Required – An Evidence-Based Approach to Stock Options
Managing 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 hold out for the highest possible price – it’s to exercise at a point when the risk outweighs the potential reward.
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 valuation tool we use internally to gauge when the time may be right 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.
Other Critical Considerations
While the Truepoint Ratio provides great insight, the decision to exercise an option should also consider cash flow needs, tax implications, and the overall impact to the 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.