Executive Stock Options: When Early Birds Aren't Always Best

You're a C-level executive with a hefty chunk of your compensation tied up in company stock options. You've been watching the market, waiting for that sweet spot where exercising makes sense. But hold on there, cowboy. There's more to this than just timing.

The Math Behind Executive Options: It's Not Just About Time

In theory, without any constraints, an American-style option should be exercised at the optimal time regardless of how many options you have. But reality isn't always so neat and tidy. When you can't short sell stocks, or even hold them (as in our example), things get tricky.

University of Cambridge and Princeton University researchers L.C.G. Rogers and José Scheinkman showed that without these restrictions, the optimal exercise time for your options might change depending on how many you have left. In other words, if you're holding a pile of unexercised options, you might find yourself exercising some early to stay below an invisible boundary.

Portfolio Implications: BAC, MS & Co.

Let's say you've got options on Bank of America (BAC), Morgan Stanley (MS), and other big players. Your optimal exercise strategy could look quite different than if you were only holding onto a single option each.

For instance, as the number of remaining options grows, you might find yourself exercising at lower stock prices. Similarly, increased risk aversion makes you more likely to exercise early. But here's where it gets interesting: time to expiry can have a non-monotonic effect. When expiration is close, you're eager to grab whatever value you can; when it's far off, you're willing to accept less because of the interest that will accrue on exercised options.

Your Action Plan: Stay Adaptive

So, what does this mean for your portfolio? It's not just about waiting for a certain stock price anymore. You need to keep track of how many options you have left, your risk tolerance, and how much time is left until expiration. Here's your action plan:

1. Regularly review your option portfolio: Keep an eye on how many unexercised options you're holding. 2. Monitor your risk tolerance: As it changes, so might your optimal exercise strategy. 3. Stay aware of the time horizon: Be prepared for non-monotonic effects as expiration approaches.