Determining the right time to exercise and sell one's employee stock options is the key to maximizing the value of this benefit. Stock options are granted at a fixed grant price that must be exercised after vesting and prior to the expiration date to realize their value. During the time between vesting and expiration (usually 10 years after the grant date) the current stock price for publicly traded companies will generally fluctuate significantly and no one can predict the peaks and valleys. Consequently, it is important to have a disciplined approach for making smart exercise and sell decisions (BTW, there is no good reason for exercising and holding Non-Qualified Employee Stock Options and here's why).

The secret to profitable employee stock option exercise decisions lies within the four main factors that affect their value:

**The length of time until expiration**; the shorter the time, the lower the probability that the value of the option will increase prior to expiration.**The in-the-money or intrinsic value**(current stock price minus exercise price); the greater the in-the-money value, the more one has to lose by continuing to hold the option.**The expected volatility of the stock**(a measure of the extent to which the price has fluctuated over time); the higher the volatility, the greater the probability that there will be higher peaks and lower valleys in the stock price prior to expiration.**The risk free rate of return**(generally the rate on 10 year Treasury bonds); an option's value is enhanced by the return on the capital that would otherwise be invested in the stock in some other investment. The risk free rate represents the return on this other investment.

The interaction of these factors is complex but there is a widely accepted methodology that uses them to calculate the full value of a stock option. The Black-Scholes formula developed by Fischer Black and Myron Scholes was awarded the Nobel prize in economics in 1997. Although the mathematics are somewhat complicated, the fundamental concept is that the value of a stock option is more than just its in-the-money value. This is based on the probability that the stock price will be higher than the exercise price before the option expires. That is why options that are underwater (current stock price less than exercise price) can still have considerable value. The difference between the Black-Scholes value (aka: Full Option Value - FOV) of an option and the In-the-Money Value (ITMV) is the "Time Value" (TV). In other words, the full value of an option *equals* the in-the-money value *plus* the time value (i.e. FOV=ITMV+TV)

If we then divide the Time Value by the Full Option Value and express it as a percentage, the resulting ratio represents the percent of the Full Option Value that is Time Value compared to the reciprocal representing the In-the-Money value. This ratio was coined the "**Insight Ratio**®" because it provides insights into determining when to exercise based on risk. For example, an option with $10,000 of vested time value and $100,000 of Full Option Value would have an **Insight Ratio** of 10% meaning that 90% of this option's value ($90,000) is currently In-the-Money value. If this ratio is low (i.e. under 15%), the option is a good candidate for exercising because there is a large amount of intrinsic value at risk compared to the probability of further gain (Time Value). To further clarify this, let's look at an example that calculates several **Insight Ratios** using the following assumptions:

- Current Date:
**8/18/19**(for calculating time to expiration) - Current Stock Price:
**$95.50**(NDAQ, for calculating intrinsic value) - Volatility:
**30%**(sources: company annual report & iVolatility.com) - Risk Free Rate:
**2.50%**(10 year treasury bill rate)

__The following observations can be construed from the above __**Insight Ratio** table (calculations by StockOpter.com):

- The first grant (N2013) is about 4.5 years from expiration but it's deep in-the-money ($66/share) so consequently it has a very low Insight Ratio. By continuing to hold this option the recipient is risking $528,000 of In-the-Money Value for $20,530 of Time Value.
- The 4th grant (I2019) is not vested so by definition the Insight Ratio is 100%. Under water options will also have an Insight Ratio of 100% because they are all Time Value.
- N2017 is In-the-Money but has 7.5 years left so Time Value makes up 32% of its full value. It would not be wise to exercise this option now because it would mean forgoing a relatively large amount of upside potential for a small amount of intrinsic value.
- The following graph clearly illustrates the Insight Ratio values compared to the intrinsic values.

Over the past 15 years the Insight Ratio has been used by hundreds of financial advisors to guide the stock option exercise decisions of their clients. Typically, an Insight Ratio of between 10% and 20% is used to trigger an exercise "evaluation." The specific ratio used to trigger action may be adjusted up or down based on the following personal financial assumptions:

**Use a lower ratio**if there are sufficient diversified assets to meet the financial goal**Use a lower ratio**if there is a long planning horizon (i.e. 10+ years to retirement)**Use a higher ratio**if you are highly concentrated in company stock and options**Use a higher ratio**if you are nearing retirement and have yet to achieve your financial goal

Let's assume the executive holding the grants listed above is 15 years from retiring, hasn't met his financial goal and is moderately concentrated in their company stock and options. Given these Insight Ratios and personal assumptions, it would be reasonable to exercise and sell the 2013 grant and then continue to monitor the other grants (particularly N2015). When the Insight Ratios go below 10% a re-evaluation of the executive's financial situation would be in order.

The secret to maximizing the value of ones employee stock options is fairly straight-forward. Commit to a disciplined approach that uses the **Insight Ratio **to compare the risk (realized intrinsic value) to the potential (time value). Otherwise, the alternatives are: 1) trying to predict when the stock price will peak or 2) hoping for the best right before the option expires.

*Bill Dillhoefer is the CEO of Net Worth Strategies, Inc. a service firm specializing in professional equity compensation risk analysis and tax planning tools. **Bill is has spoken at various industry conferences and to numerous advisor groups. Connect with him on LinkedIn or follow him **@StockOpter.*

Bill, This is great article, well explained each and everything about employee stock options. Very informative example!

Well done Bill! Critical tools to eliminate/reduce risks of emotional decision making. Thank you!