From there, it’s a short hop into the reasons the option has value—leverage, combined with insurance. For the client with an option where the strike price is $10 and the current price is $12, it’s easy to demonstrate how a bump in the stock price of a little more than 8% to $13 produces a 50% gain in free (after-tax) equity bestowed by the company (from $2 to $3). And while the leverage also works in reverse against you, it only does so down to the $10 strike price, beyond which you don’t care because you decline to exercise the option. To take such an asset, financed with an interest-free loan from the company, and cash it in—well, let’s just say that if you really need that new boat, let’s find a different way to pay for it.

We ignore, for now, the legitimate case for diversification, because it is rare that the available profits from options so narrowly in the money will make up a sizable portion of one’s portfolio. That discussion comes later.

Clients sometimes mistakenly exercise stock options to get capital gains treatment. Occasionally, a client might also suggest exercising the options quickly, when they are close to the strike price, so that he or she can bank more of the future stock appreciation by converting ordinary income to capital gains (assuming that the options are non-qualified). On the surface, it can seem to make sense. However, the first flaw in the thinking is the assumption that the stock price is going to go up. When the client exercises, he is forgoing the interest-free loan and putting only his own capital at risk by buying the shares.
With the current price close to the strike price, it’s easy enough to show how a potential, avoidable loss on the stock could dwarf the potential tax savings.

When it’s your own capital, there is also an opportunity cost—tying up the assets needed to exercise 1,000 options, for example, at the $10 strike and pay the taxes on the $2 profit. The client sacrifices the profit that the $10,000-plus might earn, just to reduce taxes on the profit that the $12,000 might make. It is difficult to imagine circumstances where that would make sense.

But what if the client argues that the other investment opportunities are lousy and that the stock is going to the moon, creating huge potential tax savings? Even if the prediction turns out to be right (and healthy skepticism about such a prediction is in order), the client will have been better off keeping the options and using the cash to buy more of the same stock. (This assumes that it is publicly traded, of course.)

How about a cashless exercise? If the client knows the stock is going up, why would he want to give up most of the shares?