Sunk-Cost Fallacy With Underwater Options

A stock option is a right to buy stock at a fixed strike price. If the stock trades below the strike, the option is underwater and its intrinsic value is zero. The option retains time value as long as it has not expired, but for deeply underwater options with limited time remaining, time value collapses to near zero as well.

Economically, deeply underwater options are close to worthless. Psychologically, they remain on the mental cap table as “my 40,000 options.” Employees spend years in decision frames that treat underwater options as real. They factor them into retirement plans. They reject job offers to avoid forfeiting them. They avoid exercising post-termination options even when a cashless exercise or a sale could capture residual value.

This pattern is the sunk-cost fallacy: the belief that past investment (the time spent at the company earning the options) justifies continued commitment to holding or “not giving up” the options, independent of their current value. The article walks through the trap and what to do with underwater options.

What “Underwater” Actually Means

An option with a strike price of $50 and a current stock price of $30 is $20 underwater per share. For 40,000 options, that’s $800,000 of intrinsic gap. The option has value only if the stock recovers above $50 before expiration.

The Black-Scholes value of the option depends on time to expiration, volatility, and the probability-weighted distribution of future prices. A deeply out-of-the-money option with 6 months to expiration at 35% volatility has near-zero Black-Scholes value. The same option with 5 years to expiration has meaningful time value (though typically 5-15% of strike).

For private-company options, Black-Scholes is rough because there is no continuous market price. The 409A valuation provides a point estimate, but the volatility input is typically higher (40-70% annualized) reflecting private-company uncertainty. Private options deep underwater against the 409A might still have meaningful option value due to high volatility.

Most underwater public-company options held by former employees expire worthless. The post-termination exercise window is typically 90 days, which is not enough time for most underwater positions to recover. For options well above strike, exercise is automatic. For options at or near strike, employees often exercise defensively. For deeply underwater options, the rational action is to let them expire, but emotional attachment causes many employees to exercise anyway, paying the strike to hold shares that may continue to decline.

The Sunk-Cost Frame

The fallacy operates as follows:

“I earned these options over four years of work.”
“If I walk away from the job, I forfeit unvested options and have 90 days to exercise vested options.”
“Exercising costs real cash ($50 strike x 40,000 options = $2M).”
“But if I don’t exercise, I ‘lose’ everything I worked for.”
“I should exercise to preserve the value.”

Each step has some logic. The final conclusion is wrong when the options are deeply underwater because exercising converts $2M of cash into $1.2M of shares (if stock is at $30). The $800K loss is locked in at exercise. If the stock falls further, the loss grows. If the stock doubles back to $60, the exercise was worthwhile.

The fallacy treats the $2M as “not a real outlay” because it “recaptures” the option value. In fact, the $2M is a new investment in employer stock at a time when the employer stock has underperformed expectations. The question to ask: “If I had $2M in cash and no options, would I invest all $2M in this stock at $30?” Almost always no. The exercise decision should mirror the hypothetical-cash decision.

The Cashless-Exercise Option (When Available)

Some private companies offer cashless exercise: the employee borrows from the company or a third-party lender to cover the strike, exercises, and sells enough shares at the next liquidity event to repay the loan. The net position after the cashless exercise is a reduced share count worth the option’s current intrinsic value.

For an option deeply underwater, cashless exercise produces near-zero net shares. The mechanic only makes sense for in-the-money options.

Some public companies allow same-day sale through a broker: exercise, sell, capture the spread. For underwater options, there is no spread, so same-day-sale is not available. The only exercise option is “pay cash and hold.”

Post-Termination Exercise Windows

The standard post-termination window is 90 days for ISOs (required under §422 for qualifying disposition treatment) and usually 90 days for NSOs (by plan convention). Some companies extend the window to 12 months, 5 years, or through expiration for various employee categories.

The standard 90-day window creates a specific trap. An employee who leaves a company with underwater options has 90 days to decide whether to exercise. Exercising requires cash (strike price times share count). Not exercising forfeits the options.

For deeply underwater options, the rational choice is to not exercise. The sunk-cost fallacy pushes in the direction of exercising anyway. Former employees who exercise underwater options to “not lose” them typically end up with concentrated positions in stocks of former employers they no longer work at, a situation with no behavioral protection (you no longer have inside information) and limited upside (if you had a strong thesis, you wouldn’t have left).

A defensible exercise of underwater options requires a specific thesis: the stock is undervalued by a specific amount, you have evidence, you are willing to deploy $2M of cash into a single concentrated position at these prices. If the thesis is “I worked hard for these options,” the exercise is sunk-cost rationalization.

Option Repricing and Reset Offers

Some companies respond to stock declines by offering to reprice options. A typical reset: surrender 10,000 options at a $50 strike in exchange for 6,000 options at a $30 strike (current price). The math reflects the reduced option count to compensate for the lower strike.

Repricing is not a sunk-cost issue per se. It is an offer the employee can evaluate on its own terms. The reset almost always improves the employee’s economic position if the stock appreciates from current levels, because the lower strike is more likely to be profitable.

Accept repricing offers if the strike is at or below current fair value and the ratio is favorable. Reject repricing offers with punitive ratios (e.g., 3-for-1 exchange for minimal strike reduction).

Note: repricing can trigger §409A issues if not structured carefully. The employer’s plan documentation typically handles this, but a repricing outside plan terms can cause immediate §409A tax to the employee.

The “Don’t Exercise to Save AMT” Trap

A different but related trap: employees who exercise ISOs when the stock is above strike, generate AMT preference income, then watch the stock fall below strike and refuse to sell because “I’d still owe the AMT but wouldn’t get the tax back.”

The AMT paid on ISO exercise is paid in the year of exercise regardless of what the stock does after. If the stock falls and the employee eventually sells at a loss, the AMT already paid may generate a AMT credit (refundable over time against regular tax). But the AMT itself is not refunded.

The sunk-cost frame: “I paid AMT to exercise, so I should hold to try to recover.” This treats AMT as a cost to recover rather than as a sunk expense. The correct frame: the AMT is spent; the current decision is about whether to hold the stock at current price. If the current-price decision says sell, sell. The AMT credit is a separate recovery mechanism that operates independently.

What to Do With Underwater Options

Compute their real value. For public options, use Black-Scholes with current inputs. For private options, use the 409A plus a reasonable volatility estimate. If the value is under 5% of strike, treat as approximately worthless.
Decide whether to exercise before termination. If you are still employed, exercising is rarely urgent. The options remain live and can be exercised at any point before expiration.
If leaving the company, compute the exercise cost and compare to cash position. Do not exercise with borrowed money unless you have a strong thesis. Do not exercise if doing so depletes your cash reserves below 6 months of expenses.
If already terminated and the window is closing, use the hypothetical-cash test. Would you buy this much of this stock at this price with this much cash? If no, do not exercise.
Do not count underwater options in your net worth. They are a lottery ticket. Treat them that way mentally. If the stock moonshots, you win. If not, no loss beyond time already spent.

Frequently Asked

Can I sell my underwater options on a secondary market? Rarely. Secondary markets price options roughly at Black-Scholes value, which is near-zero for deeply underwater options. Transaction costs eat the small residual. Private-company options generally cannot be sold at all due to transfer restrictions.

If I exercise and the stock falls more, can I claim the capital loss? Yes, when you sell. The loss is the difference between the FMV at sale and your basis (strike price plus any ordinary income from NSO exercise). The loss is a capital loss usable against gains or $3,000 of ordinary income per year.

What if I think the stock will recover in 2-3 years? Articulate the thesis. “The company has a new product that will drive revenue” is a thesis. “The company has been good historically” is not. If the thesis is weak, the exercise is sunk-cost rationalization.

Should I negotiate an extended exercise window when leaving? Yes if possible. A 12-month or 5-year window removes the time pressure to exercise. The negotiation power depends on your role and the circumstances of departure.

Does 409A apply to underwater-options repricing? Yes, potentially. Repricings that change the strike can be treated as a new grant for §409A purposes. The plan administrator typically structures around this, but confirm with the company before accepting a repricing offer.