This paper analyzes various strategies for an individual who holds a non-qualified stock option and who desires to maximize the amount of after-tax wealth generated by the option.
Contrary to most people’s expectations, assuming that the expected pre-tax return on the option is greater than zero, the optimal strategy for maximizing after-tax wealth is almost always to hold the option for as long as possible. By “hold the option for as long as possible”, we mean that the option holder should delay exercising the option for as long as is practical, taking the option expiration date, the employer’s policies, and personal cash flow constraints into account. Premature exercise is not likely to be advantageous, unless the option is in-the-money as of the decision date, and the underlying stock is expected to produce a zero or negative return between the decision date and the option expiration date.
This conclusion holds true even if the difference between the ordinary income tax rate and the capital gain rate is high, and even if the underlying stock is expected to have a very high appreciation rate.
This paper also compares the amount of after-tax wealth created by cashing out an option early in order to make an investment in an alternative investment versus early exercise of the option and then holding the option shares for long term capital appreciation.
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