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Interpretation

The measure is the intrinsic value of the option divided by the Black-Scholes value of the option. The intrinsic value is the difference between the market price of the stock and strike. It is the cash you would get (before taxes) from a cashless exercise, in which (i) the option is exercised, (ii) the stock acquired on exercise is immediately sold, and (iii) the exercise price is paid with proceeds from the stock sale. The Black-Scholes value of the option is just the famous formula tailored to the options you hold in your company's stock. If your options were transferable (and employee stock options are not), then you could sell your options in the marketplace for roughly the Black-Scholes value (or, in the case of stock that pay dividends, the Barone-Adesi and Whaley value).

The measure has the following nice properties:

- The measure is always between 0 and 100%.
- At expiration, if the options are In the money, the measure is 100%.
- If the options are Under water, the measure is 0%.
- The measure gets bigger as:
- the market price rises above the strike,
- the time to expiration of the option decreases, or
- the volatility of the stock decreases.

Typically, people exercise when the measure is about 75%.

Before expiration, if the measure is 100%, the expected present value from holding the option is equal to the value you get from exercising the option today, so exercising today is optimal.

Here are some ways to interpret a measure of 90%: A fair price in the marketplace for a tradable option that has the same strike and expiration as the employee stock option you hold is 1/90% or 111% of the value you would get by exercising your options today. Or, by exercising today, you get about 90% of the fair value of your options, where Fair value is measured using a pretty good model of how tradable options are priced in the market. Or, by exercising the options now (say to hold something less risky) you are giving up something worth 10% of the fair value of a tradable option.

In contrast, suppose the measure is 15%. Then you are giving up about 85% of the fair value of a tradable the option for some cash today. You are sacrificing a much greater potential for upside gain by exercising when the measure is 15% than when it is, say, 90%.

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Note that the Black-Scholes value applies to stocks that do not pay dividends. For dividend-paying stocks, a related value, the Barone-Adesi and Whaley value replaces the Black-Scholes value in the analysis described here.

Steven Huddart

Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA

(814) 863-0048

huddart@psu.edu

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