Intrinsic vs. Time Value

intrinsic-vs-time-value-blog-article

Nothing gets in the way of a good decision like greed. There is nothing wrong with wanting stuff, and indeed our entire economy is built upon it. However, when greed grabs hold, we can often make bad decisions that can ultimately doom our long-term success.

It’s very easy to be greedy when it comes to stock options. There are behavioral forces that work within our own brains that lead us into psychological traps. There is the ever-present FOMO where we fear getting out too early while our friends or co-workers laugh all the way to the bank. We have hindsight bias when we think about our prior decisions, and lament not doing better then. Finally, we have confirmation bias when we remember our past good decisions but tend to forget the bad ones.

Overcoming these biases is difficult. However, if we use a data-based approach to execute stock options exercise and sale we can reduce the stress and make better long-term decisions. It all starts with figuring out where most of the value of the option lies. There are two types of value for any option (whether it’s company stock, market traded, or any other future right to purchase or sell): Intrinsic or time.

The intrinsic value is the amount that you can get for the option today. It’s the pent-up gain in the underlying security subtracted by the amount needed to pay for exercise. If you can buy a share of stock today for $11, and you have to pay $1 to exercise that right, then you have a $10 per share intrinsic value for the stock.

Does that mean that if you have a stock worth $1.01 with a right to buy at $1 that your stock is nearly worthless? Absolutely not! Just because your stock today isn’t worth many multiples of the value you can pay for it now, doesn’t mean it will never be worth it. Depending on what you think the ceiling of the stock is, there may be tremendous time value embedded. This is to say if you have a long time before you are required to exercise the option you may want to wait and see.

The key is balance. For stock options that are a number of years out from the grant date or close to expiry, the intrinsic value may look really good no matter how low it may be. For newly issued options the time value may be so high that despite a nice intrinsic value, waiting may still make sense. For most people, their stock options vest in tranches, and you can make decisions on a lot-by-lot basis. After three to four years of working at a company, some options may have a much lower time value, and a substantial portion may have a smaller intrinsic value.

This means there is an opportunity to grab some gains off the table without all of the FOMO that goes along with the decision. You still must be disciplined and have a methodology. At WRP, we use specialty apps to design a selling plan that incorporates both intrinsic and time values. By using ratios, we can make informed decisions that give our clients faith that they’re making the right decision at the right time.

Of course, tax complicates things as do personal goals, but that’s why we have a tax department in house (WRP Tax), as well as financial planners to make sure that our client’s most important goals are being taken of. Reach out today if you want to have a plan based on data and academic principles.