While perusing the latest Carnival of Personal Finance this morning, I came across an entry by the Early Riser, who has worked out some simple math to determine whether it makes more sense to hold onto their stock options or to sell them instead.

Here's the basic math:

The Early Riser Stock Option Valuation Ratio (or TERSOR for short)

TERSOR = Current Stock Price / (Current Stock Price - Strike Price)

This ratio tells you how much better an alternate investment must return as compared to your employer's stock.

Well, you've got to love the built in branding! But seriously, the Early Riser provides a couple of examples to demonstrate why doing this kind of math might be useful, first with an example of when you might consider selling the options:

Stock Price = $50
Strike Price = $25
TERSOR = 50 / (50-25) = 2 or 200%

This tells you that your alternate investment must have a return that is double your company's stock return going forward. So if I expect my company's stock to return 5% per year and I can get 12% (or 240% of my company's return) in the market, I should seriously consider selling my options.

And now, an example of when you ought to consider holding the options:

Stock Price = $26
Strike Price = $25
TERSOR = 26 / (26-25) = 26 or 2600%

Now my alternate investment would need to return 26 times my company's return to equal the potential appreciation of the options.

The reason why the appeal of holding stock options changes between the two examples results from the "leveraged" effect of stock options as an investment. The Early Riser describes this effect:

The key idea here is that options (when the strike price is very close to the market price) are leveraged investments. This leverage decreases, however, as the market price rises.

Anyway, that's the discussion - here's the tool for the math:

Ah, to a job where you get stock options to have to make these kinds of decisions....

- posted by Ironman at 7:20 AM | Permalink | |