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What To Do With Underwater Stock Options?

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Underwater TigerMy wife has a whole mess of underwater options with her company, issued before the economy took a nosedive, and was looking to see what her options (ha ha) were. She’ll be leaving her company in early July, to pursue graduate school in her field, and so she’ll only have sixty days after her last day to exercise the options. For the shares that are profitable, it’s a no brainer: exercise and sell. But what can she do with the rest?

She searched the internet for advice on what she could do, fully anticipating the answer was “nothing.” Then she stumbled onto a site that said she could exercise them and use the loss to offset some tax gains. She didn’t understand why that made any sense and so she asked me. I didn’t know why that made any sense either. Since she didn’t remember where she read it, we can’t be sure the advice was serious.

I don’t think exercising underwater options make any sense. If you have $100 in capital gains, you would pay $25 in taxes (assuming 25% tax bracket); leaving you with $75 in your pocket. If you were to exercise the options and have enough loss to offset the $100 in capital gains, you would have $0 in your pocket as you took the $100 loss. Sure, the tax man gets $0, but you get $0. I prefer the scenario in which the tax guy gets $25 and I get $75 any day. If you really want the shares of stock, buy them for less on the open market. If you really want to lose money, just send it to me!

This also underscores one important rule: don’t trust everything you read and interpret it for yourself. That includes anything you read here. I have been, on more than one occasion, been wrong and, as long as I’m writing, I’ll probably be wrong again in the future. Heck, just the other day I wrote about rain barrels and did not include a warning that watering vegetables with roof runoff could be potentially dangerous!

Is there any logic to exercising underwater options?

(Photo: nikonvscanon)

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16 Responses to “What To Do With Underwater Stock Options?”

  1. ladam8518 says:

    The only reason to exercise the underwater stock options would be to claim up to a $3,000 loss to offset other taxes. Short and Long term losses offset other capital gains first and then offset regular income (losses are carried over to line 13 of the 2008 Form 1040) up to $3,000.

    In the case of your options, don’t exercise them unless required to. Offsetting $3,000 of income would cost $3,000 to save $750 in taxes (assuming 25% bracket).

    This offset tactic is usually used only with stocks that have already been purchased and are then sold at a loss to reduce taxes or other gains.

    • Jim says:

      Why would I voluntarily take a loss just to reduce my tax burden? It’s like paying $1 to save $0.25. If I had $3,000 of gains, I would pay $750 of tax and keep $2,250 of gains. If I took the $3,000 loss from underwater stock options, I would pay $750 and keep $0 of gains. I would rather pay the tax and come out ahead the $2,250.

  2. DO NOT EXERCISE

    Too many people don’t understand options (that’s why I wrote the Rookie’s Guide to Options) and those who tell you to exercise just demonstrate that fact.

    Out of the money options become worthless at expiration, but as long as time remains they have some value.

    Perhaps she can sell them to someone else who works at the company. Determining a fair value is not that difficult. If you send me e-mail – or post info here – with company name (i need to know how volatile the company’s stock is), expiration date and strike price, I can give you a good estimate of value.

    Don’t know if she is allowed to sell the options or even if she can keep them in case stock bounces. Does she have to forfeit those options when quitting?

    Do not exercise. Please. I think you already get that.

    • Jim says:

      I don’t know but I don’t think she can sell the options and she does forfeit them (she has 60 days to exercise after she quit). Let me check if she can sell them.

      • undisclosed says:

        Jim – You may also want to review the Plan whether her options are transferable. If it’s not transferable, there’s nothing you can do even though there’s some “fair value”. Good luck!

  3. I think the site may have confused selling stock at a loss with selling underwater options. These are completely different beasts.

    With underwater options, you can simply walk away and not incur a loss.

    With a stock that has tanked for you, you can’t simply walk away to avoid the loss. Unless the stock rebounds, you WILL have a financial loss at some point. You paid $100 for stock that is now worth $5. At some point, you’re going to take the hit.

    Selling the stock in order to get “credit” for the loss on your taxes often makes sense (especially in cases where it’s abundantly clear that the company is toast). After all, you already have a paper loss – why not use it to offset gains on other investments?

    Walk away from the options, fast.

    I’ll also take people’s money if they want to lose it.

  4. Kosmo:

    If the company allows the options to be transferred (i.e., sold), then walking away from them is foolish.

    If anyone wants to buy them, sell and take the little cash you can get. If there are no bids (ask co-workers) and you cannot sell, then the options are forfeited. That’s the same as walking away.

  5. Andrew says:

    I am often amazed at what people will do to get a tax writeoff. It’s as if not paying taxes is more important to them than having more money. Irrational. When I first came to San Francisco, I did word processing in a law firm that would charge clients $25K to figure out how to screw their employees out of $10K. It was as if not paying their employees was more important than the bottom line.

    • Jim says:

      It’s odd how that works sometimes, but they do say that we feel pain/loss more than we enjoy pleasure/gain, maybe that plays a role?

  6. freeby50 says:

    Underwater options are worthless and should not be exercised. I don’t know if they’d even let you exercise them.

    I can’t imagine a situation where you would be required to exercise stock options. I mean they’re called “options” as in you have the “option” to exercise them or not.

  7. freeby50:

    If you want to exercise an underwater option, it is your right to do so. They cannot prevent you from taking that action.

    But, underwater options are NOT worthless. Are you suggesting that an option to buy shares at 100 is worthless when it has 5 years of lifetime remaining and the stock is 90? That option is currently underwater, yet is quite valuable.

  8. Gates VP says:

    Jim, what are the full extent of the clauses on these under-water options?

    Are they “slightly” under-water (5%) or really worthless (25%). Do you have exercise rights into the future (typically 6 months after you leave)? If there’s a chance they can recover before they expire then it may be worth keeping cash around.

    But otherwise, yeah, they’re generally worthless.

    • Jim says:

      They are pretty worthless, the strike price is almost 75%+ than the current price and she has ~60 days to exercise. :(

  9. eric says:

    Sounds complicated but your reasoning makes sense.

  10. ilupper says:

    Actually, if the company is private and the stock is about to “take-off”, like go from $75 to $1000, it would be prudent to exercise. Because you then only take a $25 hit over a $925 * 25% tax rate which is ~$200. I said private because in a public company, you can just buy shares at a public exchange.


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