I see too many smart people with substantial gains in stock options who do dumb things. A disciplined stock option exercise strategy can prevent some big mistakes and significantly increase the value of your option grant. I try to teach my clients the following rules, which can act as a guide for you, too.

1. Don't exercise too soon. Don't wait too long.

A common reason clients give me for wanting to exercise options shortly after they vest is a significant purchase, like a fancy boat or sports car. The most expensive boat or car I can imagine is the one bought with options. If left unexercised, the options will appreciate (something a car or boat is not likely to do) and the gains will remain tax-deferred until exercise.

He exercised his options at $31, thinking this was a "spike". But the price rose to $53.

Let me explain why (in plain English and without fancy valuation models). When you exercise an option, you have to pay for it, usually from part of the gains on the option spread in a "cashless" exercise. In doing so, you lose the potential value of the future appreciation on the options you exercise and the shares you sell. This is often referred to as "opportunity cost": what you lose in exercising options too early. For example, one of my clients was granted options at $18 when the company was restructuring. The stock's price ranged from $16 to $21 for the next two years. Finally, the results of the restructuring began to appear in improved earnings. The stock then rose to $31.

Along with other executives and employees he exercised his options, thinking that the rise to $31 was a spike in the price. But the price continued to rise and, today, is at about $53. The difference between $31 and $53 is the opportunity cost of the decision to exercise while the options were relatively young.

If you wait to exercise, you realize any benefit of this opportunity. The benefit is like an interest-free loan. Look at it this way. Your options appreciate in value as the stock price rises. Since you have no tax responsibility until you exercise, it's as if your company extended you a line of credit for the difference between your grant price and the market price of your stock. But if you wait too long to exercise, there may not be enough time for the stock to recover from a temporary decline before you are forced to exercise at expiration, which leads to other points discussed below.

For thoughts on the psychology of why you may be exercising your vested options too soon and losing a big chunk of their potential value, see another article.

Study the price behavior of your company's stock.

2. Your risk rises with your profit.

As the profit in your options increases relative to the value of your interest-free loan, you have more to lose than gain because more of your own money (your potential profit) is at risk. Don't be greedy. Short-term rallies in the price of your stock are probably selling opportunities. If you expect to continue to receive future option grants, exercise your oldest (not necessarily the lowest-priced) options when these price increases occur. This requires you to spend some time in watching and understanding the price behavior of your company's stock (see the related FAQ on setting price targets to exercise and sell).

3. Consider "alternative investment cost."

Your alternative investment cost is determined by how much an alternative investment must appreciate to justify exercising your options and putting net profits into another investment.

Here is a simplified way to think about it. Let's say you have an option that was granted to you nine years ago at $3. Today the stock is trading at $62. (This would be an appreciation rate of about 40% a year, which is not unheard of for fast-growth companies.) Let's also assume that earlier in the year your stock traded as high as $64 and as low as $50. Finally, assume that if you make an investment in the market you can expect a return roughly equivalent to the return of the S&P 500 stock index over the prior 10 years. Should you exercise or continue to wait?

Determine how much an alternative investment must appreciate to justify exercising your options and investing the net profits.

I'd suggest you exercise. Here's why. The stock has appreciated at 40% a year but is trading only 3% away from its high. More importantly, it's trading 22% above its recent low. Since the stock has recently traded at both of those prices, it's reasonable to assume that it could go back to either of them again. Said another way, your opportunity cost is 3% (upside potential) and your risk of loss is 22% (downside risk).

The alternative investment cost in this example is the 3% return you must beat to exceed the expected return from holding the option. This low alternative investment cost means that your comparative future reward from holding your option has decreased and your risk has increased. At this point, you are probably better off with exercising, taking your profit, paying the taxes, and investing the proceeds in a stock or a mutual fund whose performance will complement your other holdings. (See a related FAQ on the factors that can affect your decision.)

4. Use an "average out" strategy to exercise your options.

If you intend to exercise your options in a cashless same-day sale, consider exercising monthly or quarterly, beginning two years before their expiration. You may want to set up a Rule 10b5-1 plan for prearranged trading in your company's stock. This strategy will reduce your chances of being forced to accept a lower price for all of your options by a temporary decline in the stock near expiration. If you plan to hold the exercised stock, wait until expiration to exercise. I encourage you to combine this strategy with an "average in" strategy: you invest your exercise proceeds in a diversified portfolio of stocks, bonds, and/or mutual funds on a periodic basis corresponding to your exercises.

See Part 2 of my article, with advice on your company's exercise rules and procedures, and on tax strategy, broker loans, and more. Part 5 helps you to understand the important role of diversification in your decisions, particularly when you have company stock from other sources, such as restricted stock grants.

John P. Barringer is a Certified Financial Planner™ at Executive Wealth Planning in Denver. His long career in the securities industry has allowed him to discover numerous secrets for successfully building wealth. Learn more at www.executivewealthplanning.com. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.