Employee stock options. Everybody without them wants some, and anyone with them wants more--at least until some bear market slouches our way. Yet if you're an optionnaire, I'll bet you've cursed those babies, because knowing when to turn them into something bankable is becoming a national annoyance.

That's why fresh research on how to exercise employee options caught my eye. Western Kentucky University in Bowling Green may not be the first place you'd look for help in this area. Turns out, though, that two clever accounting professors there, Joel Philhours and Charles Hays, are carving a niche on just such puzzles. Now, in June's Journal of Financial Planning, they offer a guide through the tax thicket of "nonqualified" options, the most common type, which grant employees the right to buy stock at a fixed price over a fixed term, often five to ten years. With the professors' aid, I've come up with a six-step worksheet to help you with the big question: Exercise your options now, or wait?

Before you dig in, you should know what Harold Evensky, a financial planner in Coral Gables, Fla., told me about the professors' research. "They did a very good job on it," he said. "What's missing is it doesn't take into consideration overconcentration in a portfolio." In other words, if you're deciding when to use your stock options, take a broad view of your portfolio. See if your decision would leave you too vulnerable to risks in just one investment, your company's stock or any other.

That said, how can you use what Philhours and Hays have learned? Suppose you're vested in nonqualified options on 1,000 shares at $20 a share. With the stock now at $50 a share, you've got a paper gain of 150%--congratulations! Now it gets sticky. Suppose you expect the stock to continue rising. Do you exercise the options and hold the stock? Lots of people--the profs included--have assumed this is the best path. That's because Uncle Sam taxes your immediate gain on exercising at high, ordinary-income rates, while if you hold the stock a year or more, any later gains enjoy the lower capital-gains rates, usually 20%. So by exercising your options early, you get a lower tax rate on future gains.

THE FORMULA. Yet after doing the math, the profs found the capital lost by exercising early is never recouped by later tax savings. If you must borrow the cash to exercise your options, that cost only makes matters worse. Exercise early to escape a higher tax rate, Philhours told me, "and you're going to come out behind."

That leaves two choices: Cash out to reinvest elsewhere? Or hold your options until expiration. Which will leave you richer depends on two numbers. You already know the first, the percentage paper gain on your option stock. In our hypothetical example, it was 150%. Coming up with the second number is trickier. It's the ratio of how much you expect your option stock to go up, vs. how much you think an alternative investment will rise.

Forecasting investment gains is always hazardous, but if you're managing money, it's inescapable. So suppose you think your option stock will go up 50% and an alternative will rise 75%. That's a ratio of 50 to 75, or 67%. Plug that into Step 4 of the worksheet. You'll see that cashing out option stock with a 150% paper gain and reinvesting doesn't make sense. Why? The higher gain you expect on the alternative investment isn't enough to make up for an early tax bill that cuts your capital and saps its power to compound. The worksheet shows break-even ratios for a range of paper gains.

Confused? The profs offer this rule of thumb: If you expect your option stock to rise at least 80% as much as an alternative, it's better to hold than fold, no matter how high your paper gain. I find this stuff impossible to keep in mind, so I love rules like that. And that's why, if you take my advice, you'll rip out this page and stash it with your options.

Questions? Comments? E-mail barkerportfolio@businessweek.com or fax (407) 728-1711

Before it's here, it's on the Bloomberg Terminal. LEARN MORE