There are three issues with deciding when to exercise the options:
- Taxes – obviously they should be minimized.
- Risk – given that most folks already have extensive exposure to their employers (through their human capital if nothing else) options should frequently be exercised quickly.
- Return – since the value of an option is comprised of both intrinsic value and time value, and the expirations of these options are frequently very long term, exercising early extinguishes all of the time value.
Let me dilate on that last point. For a call option, the Black-Scholes option pricing model determines the value by looking at (among other things) the time until expiration and the volatility of the underlying security. For a volatile stock with a long dated option, the time value can be significant. The only time a call option should be exercised prior to maturity (to maximize return) is if it is deep in-the-money (little leverage vs. owning it outright) and the stock pays a dividend (which you don’t get on the option). In that case, the optimal time to exercise would be immediately prior to the ex-dividend date.
To quantify this see this spreadsheet calculator I built. For example, suppose an employee has just been issued an at-the-money option on a stock that pays no dividend. The option has 10 years until expiration (he or she likely wouldn’t be vested in that yet of course). Suppose the risk-free rate is 2% and the volatility of the underlying stock is 20%. The value of the option as most people think of it is zero – it is at-the-money not in-the-money – but the actual value is about 33% of the value of owning the stock outright. Suppose five years go by, and the stock is up 50%. Most folks would be inclined to exercise, but the option is worth about 26% more than just the intrinsic value! Exercising loses all of that 26%. Of course, the return considerations I mentioned are frequently trumped by the risk issues and influenced by the tax issues. All three factors are important.