The *Insight Ratio® is a powerful metric that indicates when it is timely to exercise employee stock options and diversify the proceeds (that is, take some money off the table). The option holder, probably with the assistance of a financial advisor, selects an Insight Ratio, say 10% that is appropriate to her financial situation (e.g., risk tolerance, level of concentration in company stock and options, and time to retirement). The key is to follow the discipline of exercising and selling the underlying stock when the Insight Ratio drops below the target, as the opportunity may well be transitory. By way of example, assume that a hypothetical Intel employee holds an option with the following characteristics:
- Grant date: January 6, 2003
- Number of shares: 5,000
- Expiration date: January 6, 2013
- Exercise price: $17.18
- Insight Ratio® Trigger 10%
The Insight Ratio® dipped below 10% on May 18, 2011 when the stock closed at $23.88 per share. Unfortunately, she did not immediately take action. By August 10, 2011 the close was $19.93 and the Insight Ratio® had climbed back above 27%. If she would have cashed out on May 19 (the next trading day after the Insight Ratio trigger was reached) at the closing price of $23.54, she would have realized $31,800 compared to $13,750 on August 10. Will the stock price get back above $23.88 per share before expiration of the grant? No one knows, but she probably would have been delighted on August 10 if she had taken her money off the table at $23.75 per share.
Following the discipline of exercising and selling based on the Insight Ratio®, doesn’t ensure maximum results, but does provide substantial wealth building profits while minimizing the risk of future adverse market conditions.
* For more information on the Insight Ratio® watch the “Insight & VaR Ratios Concepts” video.
If the only choice available in managing the holding of the 5000 ESOs with a strike price of 17.81 with 19 months until expiration, your analysis is correct. But there is generally a better choice. That choice involves selling exchange traded calls and/or buying exchange traded puts as insurance on the market decline.
In your scenario, there is a current compensation tax which in some states is over 40% of the $31,800. So she would realize about $19,080 after tax. Had she bought substantially in-the-money puts in her IRA, she would have an after tax profit of about $16,000 on the puts and still own the ESOs which would be worth about $18,000 to $25,000 depending on the volatility. Had the stock increased instead of decreasing the 4 points, she would have been even better in comparison. So your suggested strategy applies only if she can not use the superior strategy.
John, thanks for your comments; I hope others will post their two cents. A few comments regarding your post:
1) The beauty of using the insight ratio as a disciplined exercise trigger is that it insures that you make a handsome profit on your ESOs and eliminates the risk of ending up with nothing. Assuming an employee’s company allows them to trade options on the company stock, the Insight Ratio trigger could also be used to sell call options or buy put options when there is a significant profit to hedge.
2) If an employee hedges with market traded options as you suggest, the question still remains as to when they should exercise their ESOs? If they don’t take the money off the table when there is a significant profit and a relatively short time to expiration, they are risking that profit.
3) As you mention, the tax will be owed at the time of exercise if the ESO is in the money. However, at today’s interest (discount) rates, the difference in Net Present Value of deferring the tax payment is very small.
CEO, Net Worth Strategies, Inc.