Subject: re : short - sell vs exercise
chonawee ,
as i have pointed out , short - selling the stock may be a bad
decision because of tax implications ( ignoring the legal aspects ) .
suppose the strike is $ 70 and you were granted an atm option .
you sell short at $ 70 ten lots ( one lot = 100 shares ) . the price goes to
$ 100 .
you lose $ 30 x 1000 = $ 30 , 000 on your short position . option exercise
gives you $ 30 , 000 . this is before taxes . you pay taxes
on your option income ( it ' s treated as ordinary income ) . the tax is
28 % x $ 30 , 000 = $ 8 , 400 . you can use only $ 3 , 000 of your loss against
ordinary income . this saves you only $ 840 in taxes .
of course , if you have capital gains , you can use losses on your option
position
as an offset .
the remaining part of your capital loss is carried forward and you get the
tax benefits over time ( less the time value of money ) , assuming you have
income in the
future ( or capital gains ) .
not so good .
by the way , valuation and optimal exercise of employee stock options
is a very interesting and difficult problem .
vince
chonawee supatgiat @ enron
07 / 10 / 2000 11 : 40 am
to : stinson gibner / hou / ect @ ect , vince j kaminski / hou / ect @ ect
cc :
subject : short - sell vs exercise
below is my writing that was originally planned to post somewhere . it
explains how to handle a special type of call options which can be exercised
but cannot be sold . ( as we know that it is never optimal to exercise a call
option before its maturity ) . however , after taking vince ' s comments on the
ordinary income / capital loss tax offsetting issue , i think this is not a good
article anymore . i guess i could just throw this article away . : - )
- chonawee
short - selling is better than exercising your employee stock options
in general , the sensible time to exercise your employee stock option is when
you speculate that ene is going down or its growth rate is extremely low . in
fact , when exercising the options , you are speculating that ene would never
reach this point ( plus interest ) again during the 10 years maturity date or
until you leave the company . if you do not anticipate that , you should hold
on to your options because you can gain higher profit by delaying your
exercise .
however , if you believe that ene is reaching its peak . then , instead of
exercising the options , you should short - sell ( or sell ) the stocks in that
amount . after short - selling , when you feel that the stock starts to go up ,
you can buy them back ( to cover ) , make profit , and still keep the options . on
the other hand , if the stock does not go down as expect , you can exercise the
options to cover your short position anytime .
let us take a look at a simple case where there are no taxes , no dividends ,
and zero risk - free rate . suppose that ene follows a simple sample path as
follow
if you exercise 100 ene options with a grant price of 45 when ene reaches 70 ,
you would earn ( 70 - 45 ) * 100 = $ 2 , 500 . but if you short sell 100 ene at 70 , no
matter how much ene is in the future , you can exercise the options to cover
the short position and still earn ( 70 - 45 ) * 100 = $ 2 , 500 . the advantage of
short - selling comes when ene at the period 2 is 60 . at this point , you can
cover your short position , get ( 70 - 60 ) * 100 = $ 1 , 000 , and still keep your
options or you can exercise the options and gain $ 2 , 500 . that is , you still
keep the flexibility of your options when you short - sell . in conclusion , the
only sensible time to exercise your employee stock options is to cover your
short position .