In The Money Options - What To Do?

[SpreadsheetMonkey]

A few years ago, my wife's company had a very generous investment option.  For every share of stock purchased through the employee stock purchase plan, they granted 3 stock options with a strike price equal to the price you paid for the shares.  I don't understand why they did it, but we purchased a few hundred shares.  The only restriction was that if you sold the stock within a certain time period (I can't remember exactly how long, but that period has expired), you had to exercise the options immediately.

We recently sold the shares in order to invest them in VTSAX.  This leaves us with the options.  They are currently in the money by a huge margin (stock price ~70, strike price ~30).  We can exercise them any time between now and 2020.  I'm trying to decide whether or not we should exercise now or wait and settle right before expiration.  I have a math and finance background, so the following explanation has me saying wait:

http://www.putcallparity.net/early-exercise-of-american-call-options

The other half of my brain is saying exercise now and buy VTSAX! The amounts in question are not make or break for us.  Does anybody have a stronger argument for exercising now and diversifying?

[YoungInvestor]

Selling the option is almost certainly better idea than exercising it, since it probably has some time value even though it's far ITM.

A 2020 option, even far itm, probably has a market value above its intrinsic value. delta is gonna be pretty much 1 on it, though, so you are exposed to fluctuations in the price that are roughly equal to the stock's variations. This option may also not be very liquid at all, which might complicate things (the bid-ask spread on it may be ridiculous).

In any case, pretty sweet investment : roughly a 533% return at this point assuming you exercise now.

[geekette]

Perhaps I'm a bit confused - these sound like they're employee stock options (although granted in an unusual way), not options that you can sell on the open market. 

If they're employee stock options, there are two common types. Nonqualified options: once you exercise them, the "bargain element" - the difference between the strike price and the fair market value when purchased - will be taxed as ordinary income (even if you don't sell the stock).

If they're qualified stock options, or incentive stock options, you don't pay taxes immediately if you hold them. 

You'll really have to pay attention to the tax implications if you sell, especially if you sell a lot in one year. 

My husband's company used to hand out stock options like candy, and we're still selling them in retirement.  A few years before he retired, they switched to restricted stock units which sadly vanished when he left.

[Khan]

A bird in the hand is worth two in the bush?

[goodrookie]

to OP, you did not mention which stock it is or even what category it belongs to. But based on the difference between strike and current price, it is either a momentum stock or one of stock beneficiary of low oil price. If it is the later, sell the option (do NOT exercise unless you want to own the stock) in open market with appropriate limit order. If it is a "momentum" stock, hard to say. You did not give enough information

[gt7152b]

Does your wife have to be employed to retain the stock option? If not, then you may want to wait until retirement to exercise so that you potentially save more on taxes. If so or if your wife plans to be with the company in 2020, I would view the options as owning shares of the individual stock. If you feel the stock is too volatile or does not have future growth then exercise/sell and purchase index funds.

[mak1277]

to OP, you did not mention which stock it is or even what category it belongs to. But based on the difference between strike and current price, it is either a momentum stock or one of stock beneficiary of low oil price. If it is the later, sell the option (do NOT exercise unless you want to own the stock) in open market with appropriate limit order. If it is a "momentum" stock, hard to say. You did not give enough information

These are definitely not the only reasons for the delta.  Depending on how long "a few years" is, it's quite easy to believe that a stock has doubled in price over time based purely on natural events and not due to something like low oil prices.

[mak1277]

Assuming you cannot sell the option...

Selling and holding is out...no reason to pay the taxes today when you have several years to either spread the tax bill (by exercising smaller amounts each year) or waiting until you're in a lower tax bracket to exercise.

Now the questions are:
1) Will the company stock outperform VTSAX?  Of course you can't *know* whether or not it will, but you see where I'm headed.
2) Do you feel comfortable with the lack of diversity of having such a big "investment" in a single company?

[GoldenStache]

Lets say you purchased 300 shares of the stock getting 900 options (assuming 1 option is 1 share not 100 shares)
If you have the 900*$30 = $27,000 on hand to execute them you could hold them for 1 year and 1 day and pay long-term capital gains taxes instead of executing and selling incurring short-term taxes (your current rate)

By waiting to sell you could save 10-20% in taxes to give you some wiggle room for your planning if the stock declines.  If you have fears that it could quickly drop back down to the $30 range than it would not be worth the additional risk (IMHO). 

You could also sell them in chunks the next few years staying in a lower bracket. 

If you don't have the 27k today you could also just do it with a portion, hold them, sell them and use the additional funds to do it again the following year.

[MDM]

Perhaps I'm a bit confused - these sound like they're employee stock options (although granted in an unusual way), not options that you can sell on the open market. 

If they're employee stock options, there are two common types. Nonqualified options: once you exercise them, the "bargain element" - the difference between the strike price and the fair market value when purchased - will be taxed as ordinary income (even if you don't sell the stock).

If they're qualified stock options, or incentive stock options, you don't pay taxes immediately if you hold them. 

geekette's questions are on point - SpreadsheetMonkey, please clarify.

[Goldielocks]

My (albeit limited) experience with stock options

Considerations:

1) Unless you have a definite tax reduction strategy, or would buy and hold this fund directly (at this price) from your cash, do not buy and hold the stock.  (Almost) no point.  Instead you can simply exercise in future when you like the sale price to the same benefit.

-- If the stock is somewhat volatile, note that exercising (selling) an option you do not yet own, is generally not a same day / same hour activity, so you will not get the price that you see when you tell your employer to sell.   So ability to quickly sell is lost.  But if this is the case, then you have a WHOLE lot more risk from volatility about the price going down than if you decide to hold them.

-- Note that some rules limit WHEN your wife (an employee) can sell.  This may hold true for personally owned stock as well as options.


2) Good idea -- Exercise these when your income is planned to be low to gain tax advantages (lower tax marginal rate)

3)NOTE  - Potential reason to buy and hold is taxation treatment...

When you buy or gain control, you owe the taxes this year (income tax, not capital gains, usually for incentive options) between the strike price and the current price, even if you do not sell.  (At least here you do, I was caught on this once). So you need cash on hand or to sell a portion of them anyway to pay the taxes.  The amount they gain after you buy them is taxed as capital gains when you sell. 

4)  Do these have an incredible cash dividend that you would like now?   If so, and you would buy the stock at this price and hold it, then ok.

My limited experience is that options are either underwater later when you think you will exercise or sell them, or hit you with surprising taxes if you try to just buy and hold.     I have never actually made money, net, doing anything other than buy and sell immediately, so if you are in the money, I say exercise them now.

[mak1277]

Lets say you purchased 300 shares of the stock getting 900 options (assuming 1 option is 1 share not 100 shares)
If you have the 900*$30 = $27,000 on hand to execute them you could hold them for 1 year and 1 day and pay long-term capital gains taxes instead of executing and selling incurring short-term taxes (your current rate)

If the options are non-qualified stock options, this is not accurate. 

With NQSOs you're taxed on the "windfall" at the date of exercise as ordinary income...whether or not you sell the shares.  Then your basis becomes the stock price at the date of exercise, which is used to calculate any future capital gains tax if you exercise and hold.

[GoldenStache]

If the options are non-qualified stock options, this is not accurate. 
With NQSOs you're taxed on the "windfall" at the date of exercise as ordinary income...whether or not you sell the shares.  Then your basis becomes the stock price at the date of exercise, which is used to calculate any future capital gains tax if you exercise and hold.
[/quote]

Correct, if they are set up at way.  Need more details on the options structure.  I am curious to see if we will get more information. 

[SpreadsheetMonkey]

I'm sorry I've been so slow to respond to my own post.  I appreciate the attention this has received.

You are correct, these are employee options.  Specifically, they are non qualified options.  You are correct that I can not sell the options. My choices(excluding exercising and holding) are:
1) Exercise now.  I would immediately sell the shares and use them to purchase VTSAX.  The difference between exercise price and strike is taxable as regular income this year.
2) Hold the options and exercise at a later date.  I would still sell the shares and purchase VTSAX. The difference between exercise price and strike is taxable as regular income at the later date.

For those speculating that this is some momentum stock or the beneficiary of low oil prices: Good guess, but I'm talking about Walgreens (WBA).  There has been some volatility over the last year because of inversion rumors, the decision not to invert, exercising an option to finish a takeover of a european chain, and the CEO stepping down.  Other than that, a totally normal stock ;).  I have no reason to believe it will out/under perform the market before the options expire in 2020.

Thank you to those who explained the (income) tax applied to the difference between exercise and strike price.  If my understanding is right, the only tax decision I have is whether or not I have a year between now and 2020 where I expect our income to fall enough for these to be taxed at a lower rate than we would right now. 

Our taxable income last year was near the dead center of the 28% bracket.  I am currently leaning towards keeping the options until the year in which we have our first child (lower income because of unpaid family leave and a dependent ).  I think that would drop us to the 25% bracket, giving us a slight savings on this transaction.  It's a small difference, but my wife has some non-index fund impulse to hang on to them.  She is NOT a company insider and has no knowledge of future performance, so don't get any ideas.

[geekette]

Options are a great thing to have!  In both senses of the word...

Just as an FYI, in our experience, when you exercise NQ options, with the bargain element being ordinary income, i.e. W-2 income, they'll take out Federal, State, and Social Security taxes for you before they cut you a check. 

One thing to consider - what percentage of your investments would this be?  You don't want to be overweighted in company stock especially since income is also tied to that company. 

[SpreadsheetMonkey]

It's only 1-1.5% of our total invested assets.  I agree with not investing much in the company that send your paychecks but that doesn't feel overly concentrated to me.

Good point on the withholding.  Fidelity has an exercise estimation tool where you get to input the withholding rate.  The default is almost 40%!  It's not often you see it listed in percentage terms like that.  Ouch.

[Heckler]

A bird in the hand is worth two in the bush.

My only experience with options is a 2012 bonus with options for 1500 at $50 something.  They vested this past month, and "luckily" I got to sell the options back for shares, but I had to sell immediately at market price.  $4 per share made me ~$300 after taxes and fees.

Cash them in before the company tanks like mine did.  Go for the average.

[Heckler]

My sister in law had ten years of bonuses paid in Nortel options.  How'd that go for her?

[clifp]

I'd be inclined to hold on to them until 2020, or do as  you thinking waiting until you drop into a lower bracket.

If in fact WBA behaves like the rest of the market (and it strikes me as about an average big cap stock as you could ask for) Mathematically you are better off waiting until 2020 to exercise them.
Since you are spreadsheet guy I'd model different scenario of the  performance WBA vs the market, in general WBA would have to under perform the market by quite a bit for you to come out ahead by exercising today and buying Total Stock Market Index.

I guess I am the opposite of Heckler's sister. I made quite bit of money by holding off on my non qualified Intel option until right before expiration.  In the interest of diversification, I did exercise, wait a year and sell most of my incentive stock options.

[josstache]

Figuring this out (including the tax aspects) may be relatively complicated, but it sounds like a decent chunk of money.  Since the gist of your post is that you'd rather transfer the equity represented by these options to Vanguard, you may want to hedge the options and use the proceeds to invest as you wish.  According to the almighty Wikipedia:

"However, taxes can be delayed or reduced by avoiding premature exercises and holding them until near expiration day and hedging along the way. The taxes applied when hedging are friendly to the employee/optionee."

[mak1277]

I'd be inclined to hold on to them until 2020, or do as  you thinking waiting until you drop into a lower bracket.

If in fact WBA behaves like the rest of the market (and it strikes me as about an average big cap stock as you could ask for) Mathematically you are better off waiting until 2020 to exercise them.
Since you are spreadsheet guy I'd model different scenario of the  performance WBA vs the market, in general WBA would have to under perform the market by quite a bit for you to come out ahead by exercising today and buying Total Stock Market Index.

Why do you believe the bolded part is true?  If WBA performed exactly as the rest of the market, then there's no difference between holding the shares until 2020 compared to exercising today and investing in the total market (except for any difference in fees).  If you're in Vanguard, the fees wouldn't make that big of a difference. 

And, you may actually lose out by holding longer if your marginal tax rate on ordinary income exceeds your capital gains rate, since the delta between option price and stock price is likely to grow as you wait until 2020.

[clifp]

I'd be inclined to hold on to them until 2020, or do as  you thinking waiting until you drop into a lower bracket.

If in fact WBA behaves like the rest of the market (and it strikes me as about an average big cap stock as you could ask for) Mathematically you are better off waiting until 2020 to exercise them.
Since you are spreadsheet guy I'd model different scenario of the  performance WBA vs the market, in general WBA would have to under perform the market by quite a bit for you to come out ahead by exercising today and buying Total Stock Market Index.

Why do you believe the bolded part is true?  If WBA performed exactly as the rest of the market, then there's no difference between holding the shares until 2020 compared to exercising today and investing in the total market (except for any difference in fees).  If you're in Vanguard, the fees wouldn't make that big of a difference. 

And, you may actually lose out by holding longer if your marginal tax rate on ordinary income exceeds your capital gains rate, since the delta between option price and stock price is likely to grow as you wait until 2020.

Cause I did the math..

To make the math easy let says the OP has 1,000 share of WBA with strike price of 30 he exercises and sells at $75/share.  This gives a profit of $45K he owes taxes (fed 28%, and lets say 5% state) this leaves him 30K in total market .  Over the next 5 years the total return of total market (VTI) is 50% (about equal to the 9% average market gain/year compounded ).  At the end of 5 year is worth $45,000 (we'll ignore taxes on dividends along the way). He sells VTI and pays taxes on the $15K profit (15% fed cap gains 5% state) or $3,000 leaving him with $42,000.

If he choose to not exercise and WAB also goes up 50% rising from $75 to $112.50 over the next 5 years (again ignoring the 1.5% dividend of WBA). He exercise the options and is left with a profit of $82,500 ($112,500 -$30,000).  He owes 33% tax on that  leaving him with $55,275 after tax or $13,000 ahead of exercising now.

The options provide the OP with an interest free leverage.  A back of the envelope say that if the market appreciate 50% over 5 year as long as WBA appreciates 30% or more he comes out a head not exercising until 2020.  Now leverage works both ways and if the market is lower 5 year from now he is better off exercise and now.  But of course if you think stocks are going to be lower 5 years hence, he the OP shouldn't invest in the total stock market, but rather in 5 year CD.

[mak1277]

I'd be inclined to hold on to them until 2020, or do as  you thinking waiting until you drop into a lower bracket.

If in fact WBA behaves like the rest of the market (and it strikes me as about an average big cap stock as you could ask for) Mathematically you are better off waiting until 2020 to exercise them.
Since you are spreadsheet guy I'd model different scenario of the  performance WBA vs the market, in general WBA would have to under perform the market by quite a bit for you to come out ahead by exercising today and buying Total Stock Market Index.

Why do you believe the bolded part is true?  If WBA performed exactly as the rest of the market, then there's no difference between holding the shares until 2020 compared to exercising today and investing in the total market (except for any difference in fees).  If you're in Vanguard, the fees wouldn't make that big of a difference. 

And, you may actually lose out by holding longer if your marginal tax rate on ordinary income exceeds your capital gains rate, since the delta between option price and stock price is likely to grow as you wait until 2020.

Cause I did the math..

To make the math easy let says the OP has 1,000 share of WBA with strike price of 30 he exercises and sells at $75/share.  This gives a profit of $45K he owes taxes (fed 28%, and lets say 5% state) this leaves him 30K in total market .  Over the next 5 years the total return of total market (VTI) is 50% (about equal to the 9% average market gain/year compounded ).  At the end of 5 year is worth $45,000 (we'll ignore taxes on dividends along the way). He sells VTI and pays taxes on the $15K profit (15% fed cap gains 5% state) or $3,000 leaving him with $42,000.

If he choose to not exercise and WAB also goes up 50% rising from $75 to $112.50 over the next 5 years (again ignoring the 1.5% dividend of WBA). He exercise the options and is left with a profit of $82,500 ($112,500 -$30,000).  He owes 33% tax on that  leaving him with $55,275 after tax or $13,000 ahead of exercising now.

The options provide the OP with an interest free leverage.  A back of the envelope say that if the market appreciate 50% over 5 year as long as WBA appreciates 30% or more he comes out a head not exercising until 2020.  Now leverage works both ways and if the market is lower 5 year from now he is better off exercise and now.  But of course if you think stocks are going to be lower 5 years hence, he the OP shouldn't invest in the total stock market, but rather in 5 year CD.

I clearly underestimated the impact of the timing of the tax bill.

I was originally 100% in favor of immediate exercise...now I'm probably 50/50 after looking at the math.  I still think locking in a gain and diversifying is a good thing, because the only true negative outcome is if the stock price falls below the exercise price.

[goodrookie]

It is ridiculous to hold that much money in 1 stock just to save on tax bills. (Whatever happened to capital preservation?) Do you have any idea how much Walgreen would be in 5 years? Its P/E is high and as far as I know it has no significant advantage compare to CVS, Rite aid, etc.
If OP is so certain that WalGreen is a gold mine, he can sell the positions today and use 50% of the profit to buy LEAP and make more than a few bucks. (2017 Jan 80 call is only $7)

[clifp]

It is ridiculous to hold that much money in 1 stock just to save on tax bills. (Whatever happened to capital preservation?) Do you have any idea how much Walgreen would be in 5 years? Its P/E is high and as far as I know it has no significant advantage compare to CVS, Rite aid, etc.
If OP is so certain that WalGreen is a gold mine, he can sell the positions today and use 50% of the profit to buy LEAP and make more than a few bucks. (2017 Jan 80 call is only $7)

Did you read the OPs comment since when is 1.1-5% of your net worth a ridiculous amount of money. I never seen any financial advisers express concern about concentration for any position less than 4-5%.  Frankly, selling the stock paying the taxes and then buying LEAPs is positively the worst idea of all.  Now selling LEAPs might makes sense if you trade Jan 2020 LEAPs but you can't.

I showed in my earlier post how he made more money holding on to the options if the market goes up the average amount, and came out ahead even if Walgreen trailed the market modestly.  Speaking of capital preservation what happens if we have a depression and the market goes down by 2/3 and poor Walgreens goes bankrupt by 2020.  How much does the OP lose buy waiting until 2020?  Not a dime, instead the OP walks away from the worthless options, without owing anything.

[ubermom4]

OP -- great questions to ask and very complicated. We have some experience with stock options-- good and bad ;)   Firstly, I don't know if you live in a high tax state but you should be aware of a nasty beast called the Alternative Minimum Tax which can hit you when you exercise. Too complicated for me and extremely nasty. Check it out. My DH worked at a company when the stock was trading in the 90s and then for several reasons and over several months the stock went to the 20s and stayed there for almost a decade. The company was still profitable and did not have huge layoffs but many employees got stuck because they had planned on getting their option money which they had saved over many years. It was very tough. Fast forward. DH is with a different company now and has a more 'sophisticated' plan. When the stock is way up (if you can figure that out, let me know) he sells some options, regardless of whether or not we 'need' the money. He also looks to see if the executives are selling -- not always a good indicator but more data to chew on. The top 5 executives have to file Form 4s with the SEC when they trade company stock.   You don't have to sell your entire position -- sell  a quarter of it (or somesuch) so you lock in some of the gains. Cashing in your options is mostly emotional -- the psuedo math stuff like Black, Scholes is bunk. Hope this helps. In the money options are a great 'problem' to have.

[clifp]

Alternative minimum tax (AMT) is really only a consideration when exercising Incentive Stock Options (ISOs). These options are non qualified so any profit is treating as ordinary income and there is no advantage to exercising and holding, like there is for an ISO like I think your husband had.

Black Scholes is not bunk, even if you don't understand math, it is pretty important to understand the concept. This is one of those situation where this no need to let emotions get in the way of making a good decision, it is not a make or break amount of money for the OP. But it is none trivial amount of money, several thousand dollars.

Having the rights to buy stock at $30 that is worth $75.59 today is valuable.  How valuable it is depends on three factors, how long the options have to expire, how much the options are in the money, and volatile the stock is.  A stock like Wallgreens doesn't move around a lot like Apple, or Netflix, or Tesla.  So if options expired the value of the options might only be the profit $45.59 + $.20 or so. The longer the options the more valuable they are.  At 2 years the value of owning these options is about $2. Options that expire 5 years out are worth precisely (Black Scholes, Nobel prizing winning work) the square root (5 years/2 years) or 1.58 times more than 2 years options, or a bit over $3. 

Exercising these options today is the same as taking $3/share and flushing the money down the toilet. 
It is as anti-mustachian as buying a pair a shoes and tossing the shoes into the trash after wearing them once.

[goodrookie]

Assuming OP's wife will remain employed at Walgreen, it is a BAD idea to hold onto these options. It is deep in the money option; so, it acts like a stock more or less. But place of employment should be different place of investment. It is basically diversification by another name. (E.g. if you work for Delta, you shouldn't own too much of DAL because your income and investment are correlated. Same principle for OP's family.)

OP should wait until he becomes a father (in 1-2 year) and then sell the stocks+options.
Essentially, the question is will WBA increase > some other stocks/ETF? Its P/E of 35 vs S&P's 16-17 and the competitions make me think twice before suggesting he should wait until 2020.

@clifp: His options' expiration date is 2020 (t=5 years). The time values get lost the further he waits. Exercising (he can't sell) now vs in 2017-2018 does not make a difference but it does become a factor the closer he gets to 2020. Since it's deep ITM, it's essentially a stock that will start losing its value beginning 2019. If OP thinks WBA is the next big thing, he can own its stocks outright.

[clifp]

Assuming OP's wife will remain employed at Walgreen, it is a BAD idea to hold onto these options. It is deep in the money option; so, it acts like a stock more or less. But place of employment should be different place of investment. It is basically diversification by another name. (E.g. if you work for Delta, you shouldn't own too much of DAL because your income and investment are correlated. Same principle for OP's family.)

OP should wait until he becomes a father (in 1-2 year) and then sell the stocks+options.
Essentially, the question is will WBA increase > some other stocks/ETF? Its P/E of 35 vs S&P's 16-17 and the competitions make me think twice before suggesting he should wait until 2020.

@clifp: His options' expiration date is 2020 (t=5 years). The time values get lost the further he waits. Exercising (he can't sell) now vs in 2017-2018 does not make a difference but it does become a factor the closer he gets to 2020. Since it's deep ITM, it's essentially a stock that will start losing its value beginning 2019. If OP thinks WBA is the next big thing, he can own its stocks outright.

@Cathy good research.  It is highly unusual for people to be able to sell employee stock options of any form. I some case you sell public options and capture the premium which would be a reasonable strategy but Jan 2020 with 30 strike aren't traded so that isn't a strategy for the OP. Perhap in 2018 he could do that.

Goodrookie you failed to address my point that it is only 1-1.5% of the OPs net worth.   Sure if it was 50% of their net worth that would true, maybe even 10-15%, at this level her employment are irrelevant..

You also failed to provide any reason to sell other than you think WBA is overvalued because its P/E is high.  So what lots of stock in the S&P (which FYI > 19 right now) have high P/E, that one statistic alone doesn't make the stock overvalued.  By this logic  Netlfix, or Tesla, or Facebook would all be fraction of their price.

Yes it deep in the money option that behave more like a stock than options. It is also 2x leverage, which is interest free, and with the really nice feature if the financial world collapse you can walk away with no harm.

[goodrookie]

I don't think OP is reading this anymore. So, I'll make this my last post on this thread.

I am going to guess OP belongs to upper middle or elite class. His net worth is probably around $2-2.5 million liquid asset (closer to 3 million with real estate). Yearly family income is likely 200k (btw, I think his wife make more money than he does). So yes, this investment (or more like income package) is a relatively small amount of money. BUT MONEY IS MONEY. Being rich gives you more risk tolerance- not a license to ignore downfalls or miss opportunities to maximize profit.

Let's assume his wife got 333 stocks and 1K options which he can't sell but only exercise. In this case, 1 option = 1 stock (not 100 stocks). He already sold his stocks. So, the options are NOT 2x leverage. It is also not valueless. So it's wrong to say "if the financial world collapse you can walk away with no harm." The harm would be that he would be out of (75.60-30)*1000*(1-whatever his tax brackets is) ~ $33,000

Even if WBA stays relatively flat, he starts to lose money around 2019 because of the time decay. And because it is deep in the money, he shouldn't expects the options to rise dramatically in values if WBA does become a rockstar stock. Might well own the stock outright in that case.

Also to conclude: Facebook=momentum stock Netflix=big risk stock Tesla= pure speculation. Walgreen is not exactly in the same category.

[TreeTired]

Although you cannot sell the options,  are you allowed to sell (naked) exchange traded calls?    I am guessing not -  typically an employee is not allowed to sell calls on the company he works for.    That is the only way I know of that you could hedge the position in order to capture the time value of the options.   As you figured out (from the linked article) if you exercise now or any time before 2020 you are giving up the time value of the options.   Economics/math tells you to hang onto them until 2020, or at least until your income drops putting you in a lower tax bracket.