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Derivatives and tax strategies

Consider the following hypothetical situation:

You have hold vested options to buy 15,000 shares at an average strike price of $16. The market price of the stock is now $90.

Should you:

  • Sell calls against the stock?
  • Use a zero-cost collar to lock in the existing appreciation and defer the time until the at which income is recognized and taxes are paid?
  • In the case of a collar, what strike and expiration date should be chosen for the two legs of the collar?

Here are two questions to consider:

Question 1

If your options were tradable, would you be willing to sell them today for their fair value in the marketplace?

Question 2

How different is the fair value of a tradable option (with the same terms as the non-transferable options you hold) from the before-tax proceeds you would receive by exercising today?


The answer to Question 1 depends on your personal attitude toward risk and whether you are bullish or bearish on the stock. If you dislike risk and/or are bearish on the stock, then the answer to Question 1 may well be yes.

Question 2 is hard to answer unless you know the fair value of a tradable option with the same terms as the non-transferable options you hold. The options in the example are deep in the money since the market price of the stock is more than 5 times the strike. In such situations, you capture almost the entire fair value of a tradable option with similar terms by exercising immediately.

Thus, the answer to Question 2 likely is that the fair value is close to the before-tax proceeds from exercising the options now. This means you give up little of the value of your options by exercising them now. Alternatively, the amount you can expect to get by holding your options is about what you would get by exercising today.

The option calculator is a tool to assess how close the fair value is to the before tax proceeds from exercising the options now.

So, if your answer to question 1 is 'Yes, if I could sell my options today for their fair market value, I would', and your answer to question 2 is 'The fair market value is quite close to the before-tax proceeds from exercising today', then immediate exercise is a good strategy unless you have strong reasons to believe that further appreciation in the stock is likely. (The evidence is that employees do condition their exercise decisions on foreknowledge of future stock price movements. See Information distribution within firms: evidence from stock option exercises.) Immediate exercise and sale of the stock you acquire would allow you to invest the proceeds in a diversified portfolio of assets.

Buying puts

If you want to lock in your existing gain, yet participate in possible future stock price increases, you could buy puts. To get an idea of how much this would cost, you can get current quotes by entering your company's ticker here:

Ticker of your company's stock:  

Don't know your company's stock Ticker?
Ticker symbol lookup (Opens a new window.)

The strike price of the put is the value of the stock that you protect. The more value you want to protect, the higher the price you must pay to buy the put. LEAPS (a long-dated put) will let you protect the value for more than a year. The longer you want the put to stay alive, the more it will cost.

To get the cash needed to buy the puts, you could exercise some of your options.


Tax considerations should also play a role in your decision. In the example, exercising all the options at once would trigger income of about $1,110,000 (i.e., 15,000*($90-$16)). This much income would almost certainly place you in the top tax bracket at the federal level. If your income from sources other than these stock options generally places you in a tax bracket lower than the top one, then spreading the exercise of your options over two or more tax years means that a portion of your option income will be taxed at a lower rate in each year.

Current federal tax schedule are available at:

Here is a sample schedule:

Married Individuals Filing Joint--2004

      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$ 0 $ 14,300 $ 0.00 10 $ 0 14,300 58,100 1,430.00 15 14,300 58,100 117,250 8,000.00 25 58,100 117,250 178,650 22,787.50 28 117,250 178,650 319,100 39,979.50 33 178,650 319,100 ....... 86,328.00 35 319,100

Using this schedule as an example, if your but-for-options taxable income were $117,250, then the next $61,400 of income would be taxed at 28%. A further $140,450 would be taxed at 33%, and any amount over that at 35%. Having $1 of income taxed at 28% rather than 35% saves you 7 cents of tax. So, the tax benefit on that first $61,400 is $4,298. Similarly, the tax benefit from having the next $140,450 taxed at 33% rather than 35% is 2 cents per dollar of income, or $2,809 in total.

Phaseouts make and state income taxes make things more complicated, but the basic idea is the same.

In deciding whether to stagger exercise over two or more years, an important and sometimes overlooked tax consideration is the possibility that personal rates will differ across years. Anticipated increases in tax rates favor early exercise. Anticipated decreases in tax rates favor delayed exercise. Changes in tax rates can swamp the effects of staggering exercise to take advantage of lower rates for lower income brackets. In the recent past, the top federal rate has been as high as 39.6% and as low as 28%. To get an idea of tax rate volatility over time, you can look at this chart of Top US Tax Rates over Time.

The tax benefits from staggering the exercise of your options are real, but obtaining them means delaying the exercise of some options. This prolongs your exposure to the risk of stock price fluctuations.

It is important to note that company policy and SEC rules may restrict the ability of some individuals to undertake some of these strategies. For instance, a person classified as an insider for purposes of Section 16 of the Securities Exchange Act of 1934 may be prohibited from buying puts or implementing a collar around his stock options position. Section 16 insiders may be able to sell out-of-the-money calls against their in-the-money stock options.

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Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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was last updated on Tue, Aug 21, 2018.
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