Can you exercise underwater stock options?

Can you exercise underwater stock options? This guide explains what 'underwater' means for ISOs and NSOs, legal and plan constraints, public vs private company differences, tax and AMT implications...

2026-01-07 01:26:00

By Lily Wong

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Can you exercise underwater stock options?

Can you exercise underwater stock options? In short: yes — in many plans you legally can exercise options whose strike price is higher than the current fair market price — but exercising underwater options is usually economically disadvantageous for public company awards and has limited tax benefit. This article explains what "underwater" means, how plan terms and law affect your rights, the key tax differences for ISOs and NSOs, the practical distinctions between public and private companies, strategic alternatives (repricing, exchanges, buyouts, waiting), and a step‑by‑step checklist to decide what to do.

As of January 15, 2026, according to NASPP reporting, many companies continue to face underwater option populations after sustained market volatility. As of January 10, 2026, Cooley GO guidance noted common repricing mechanics for private companies and the compliance steps employers typically follow. As of December 12, 2025, J.P. Morgan Workplace Solutions and GlobalShares materials highlighted that employees in public firms rarely exercise underwater options, favoring cashless methods when in‑the‑money.

If you want the short take: you can often exercise underwater options if your award and plan allow it, but doing so usually creates an immediate loss and does not provide tax relief. Private company cases and certain strategic reasons can change that calculus. Use the checklist section below and consult a tax advisor before acting.

Definition and scope

"Underwater" stock options are options whose exercise (strike) price exceeds the current fair market value (FMV) of the underlying shares — i.e., they are out‑of‑the‑money. Key terms:

Exercise/strike price: the price per share you must pay to convert an option into stock.
In‑the‑money vs out‑of‑the‑money: in‑the‑money options have positive spread (FMV > strike). Underwater or out‑of‑the‑money options have negative spread (FMV < strike).
Vested vs unvested: only vested options can typically be exercised (subject to plan terms and early‑exercise provisions).
Expiration: options have finite terms; expiration and post‑termination exercise windows govern timing.

This article focuses on employee stock options in the U.S. context: Incentive Stock Options (ISOs) and Non‑Qualified Stock Options (NSOs / NQSOs). It treats public and private companies separately because liquidity and valuation differences materially change the decision.

Legal and plan constraints on exercising

Your right to exercise is first a contractual question under the employer's equity plan and your award agreement. Plan and award provisions control:

Vesting schedule: only vested shares are typically exercisable unless your plan allows early exercise.
Exercise window and expiration: most plans specify the term (e.g., 10 years) and any shortened post‑termination exercise window (commonly 90 days, unless extended).
Transfer and repurchase rights: private companies often retain repurchase rights (right of company to buy back shares on termination at FMV or cost).
Payment methods: plans may permit cash, check, wire transfer, cashless/sell‑to‑cover, or third‑party financing (public companies). Private firms may restrict cashless exercises.
Employer adjustments: companies may amend plans (subject to board approval and sometimes shareholder approval) for repricings or exchanges.

Employers generally cannot force you to exercise options beyond plan rules. Conversely, employers may modify award terms per plan amendment clauses and applicable law, but material changes (like repricings that dilute shareholders) can require board/shareholder approval and have accounting/tax consequences.

Practical difference — public company vs private company

Public companies

For employees at public companies, the market sets a clear FMV. Exercising underwater options in a public company is usually illogical because you can buy the same shares on the open market for less than the option strike price.

Common exercise methods in public companies:

Cash exercise: you pay the strike price and receive shares. If underwater, you pay more than current market price and take an immediate unrealized loss.
Cashless exercise / sell‑to‑cover: a broker advances funds or sells a portion of shares immediately to cover strike and taxes — typically only available when options are in‑the‑money.
Broker financing / stock loans: some brokers offer margin or loan products to enable exercise, but these carry interest and margin risk.

Practical considerations for public company holders:

Liquidity: public markets allow immediate sale, so there is little reason to exercise at a price above market.
Immediate loss: exercising underwater creates a realized cash outflow at a worse price than buying on market.
Taxes: for NSOs you recognize ordinary income on the spread at exercise — if the spread is negative, there is no income to recognize; but there is also no tax deduction for a loss realized by paying more than market.

Given these points, employees of public companies rarely exercise underwater options absent unique contractual reasons.

Private companies

Private company situations differ substantially. There is no public market price and no easy way to convert options into cash unless the company facilitates a secondary, liquidity event, or exit. That changes the calculus:

Early exercise: some private companies permit early exercise of unvested options so employees receive shares subject to repurchase on vesting schedule; this can start the holding period for ISOs and capital gains treatment.
409A valuation: private companies obtain a 409A valuation to set FMV for option grants and tax compliance. You typically cannot rely on an older 409A if the company updates it.
Repurchase/rights of first refusal: many private companies have rights to repurchase shares or a right of first offer/first refusal on transfers.
Liquidity constraints: exercising in a private firm often means paying cash for illiquid shares — the risk is that the company might never have a liquidity event.

For private company employees, exercising underwater options might still be considered for reasons such as starting the capital gains holding period, expecting near‑term recovery or exit, or to participate in secondary markets if available (subject to company approval). However, if strike > safe harbor FMV (409A), exercising creates downside risk and does not generally realize a deductible loss for tax purposes.

Can you (and should you) exercise when underwater? — short answer and intuition

Can you exercise underwater stock options? Yes in many cases, subject to plan terms. Should you? Generally no for public company options — buying the stock on market is cheaper and taxes do not favor exercising. For private companies, the decision depends on liquidity prospects, tax timing (e.g., starting ISO holding periods), repurchase rights, and personal risk tolerance.

Intuition:

If the option is underwater in a public company, exercising substitutes a more expensive share purchase for a cheaper market buy — almost always undesirable.
In private companies, exercising may be the only path to ownership and to start long‑term capital gains holding periods, but it requires cash and accepts illiquidity and valuation risk.

Tax consequences and rules

Tax treatment differs by option type. Note: tax law is complex and facts matter. Consult a qualified tax advisor.

Incentive Stock Options (ISOs)

Exercise tax: upon exercise of an ISO, generally no regular federal income tax is due. However, the bargain element (FMV − strike) can trigger Alternative Minimum Tax (AMT) adjustments.
AMT: AMT treats the bargain element as an adjustment, which can create AMT liability if the spread is positive. If the option is underwater (negative spread), there is no AMT preference from exercise.
Negative spread: exercising an ISO when the FMV is below strike creates no tax benefit. You can’t claim a current deduction for paying more than FMV.
$100,000 rule (Section 422(d)): ISOs that become exercisable in a year with a value over $100,000 are treated differently; be mindful of ISO limits.
Disqualifying disposition: selling shares before the required holding period converts the tax treatment to NSO‑like ordinary income for the spread.

Non‑Qualified Stock Options (NSOs / NQSOs)

Ordinary income: for NSOs, you generally recognize ordinary income at exercise equal to the spread (FMV − strike) on the exercise date.
If underwater: when FMV < strike, the spread is negative and there is no ordinary income; you also generally do not realize a tax loss at exercise. Taxable events are tied to positive spreads.
Cost basis: your cost basis is strike + any income recognized at exercise. At a later sale, capital gains or losses are computed from that basis.

Section 409A valuations and private company issues

409A sets FMV for nonpublic companies. Employers rely on a 409A valuation to avoid deferred compensation penalties.
Exercising at a strike above a later 409A does not create a deductible loss for the employee. A low 409A helps protect option grants from being taxed at grant, but it does not make an underwater exercise tax‑advantageous.

Summary: exercising underwater does not generate tax losses or reduce AMT in normal circumstances

Generally, exercising underwater options does not produce a current tax deduction or reduce AMT because tax rules usually recognize income only when spread is positive or upon sale. A transaction that requires paying more than current FMV does not translate into an immediate tax benefit for the employee.

Financial and economic implications

Key economic consequences to weigh:

Immediate unrealized loss: paying more than market for shares is an immediate economic loss compared with buying on market (public company) or compared with future valuations (private company).
Cash outflow and opportunity cost: exercising consumes cash that could be used elsewhere or to diversify concentrated positions.
Dilution and capitalization: employers may repricing or grant refresh awards that change dilution; exercising itself does not typically change company valuation but increases outstanding shares.
Liquidation waterfall and preference: in an exit, common stockholders (typical option holders) rank below preferred; exercises increase common share count that may not change outcome but can matter in partial liquidity events.
Holding period and capital gains: exercising early (in private company) can start the long‑term capital gains clock; that may be valuable if the company later exits at a higher valuation.

Alternatives companies and employees commonly pursue

Wait / do nothing

Rationale: let options remain outstanding in hope of recovery. Risks include expiry and losing options if you leave employment.

Repricing or option exchange (option‑for‑option)

Repricing: employer reduces strike price of existing options to restore value; often requires board and sometimes shareholder approval.
Exchange: employees surrender underwater options and receive new grants (often with new vesting). Exchanges can trigger accounting (ASC 718) and tax consequences and are scrutinized by proxy advisors.
Issues: repricing without shareholder approval can be controversial; accounting expense and investor reaction may be significant.

Grant supplemental awards or buyouts

Refresh grants: companies may issue additional options or restricted stock to restore employee incentives.
Cash buyouts: employer purchases underwater awards for cash — costly to employer and not always preferred.

Extend expiration or modify terms

Exercise‑window extension: extending post‑termination exercise windows (e.g., from 90 days to 1 year) does not change intrinsic value but can preserve optionality for employees.
Legal/tax ramifications: extensions can raise Section 409A or accounting issues and need careful drafting.

Tender/issuer exchange rules and SEC considerations

For public companies, exchanges and repricing programs must comply with securities laws and may require disclosure to shareholders.
Issuers often obtain legal and accounting guidance for any program that materially affects executive compensation.

When exercising underwater might make sense

Scenarios where exercising underwater may be reasonable:

Private company and you want to start the capital gains holding period (often via early exercise) and you expect a recovery or exit.
Imminent expiration or you face termination with a short post‑termination window and believe the company will recover before exit — though this is speculative.
Specific contractual reasons (e.g., to preserve rights attached to share ownership) such as voting or participation in secondary transactions.
Rare tax strategies under specialized circumstances — consult a tax professional.

Note: tax reasons alone rarely justify exercise when underwater. The economic and liquidity risks typically outweigh speculative tax benefits.

How to make the decision — practical checklist

Use this checklist before exercising or negotiating alternatives:

Review plan documents and award agreement: confirm vesting, exercise windows, repurchase rights, transfer restrictions, and permitted payment methods.
Confirm current FMV: for public companies, check the market price; for private companies, obtain the latest 409A valuation.
Check expiration and post‑termination windows: note any impending deadlines.
Assess liquidity prospects: is there a secondary market or is an exit likely in your horizon?
Quantify cash needs: calculate required cash to exercise and potential taxes. Consider opportunity cost.
Model outcomes: run scenarios (best, base, worst) for company valuation and timing of exit.
Tax analysis: evaluate ISO AMT exposure and NSO ordinary income timing. Consult a tax advisor for AMT modeling if ISOs are involved.
Consider negotiation: discuss repricing, extensions, supplemental grants, or buyouts with employer if appropriate.
Consult professionals: attorney and tax advisor, especially for private company cases and complex employer proposals.
Decide on the method: cash, cashless (if available), or third‑party financing; for private firms, consider early exercise vs wait.

Practical steps to exercise or pursue alternatives

If you decide to act, follow these steps:

Gather documents: award agreement, plan, any amendment notices, and latest 409A if private.
Contact plan administrator or HR: request exercise packet, current FMV, and repurchase policy.
Choose exercise method: pay cash, use broker financing (public companies), or arrange settlement terms with the company for private cases.
Coordinate tax planning: estimate tax consequences and prepare to cover withholding for NSOs if applicable.
Execute paperwork: complete exercise notice, payment, and tax forms.
Recordkeeping: keep transaction records for basis and future tax reporting.
If negotiating alternatives: prepare a brief, objective case for repricing or refresh awards focused on retention and alignment; employers often evaluate across the employee population.

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Risks and common pitfalls

Common mistakes and how to avoid them:

Exercising without tax review: avoid acting without modeling AMT or ordinary income outcomes.
Misreading plan terms: confirm vesting, exercise deadlines, and repurchase rights in writing.
Assuming tax loss on exercise: paying more than FMV does not create a deductible tax loss at exercise.
Ignoring liquidation preferences: remember preferred stock liquidation rights can reduce value to common holders at exit.
Overconcentration: do not use all your liquid assets to exercise options, especially if company prospects are uncertain.

FAQs

Q: Will exercising underwater create a tax loss I can claim? A: No. Exercising an option by paying more than FMV typically does not create an immediate deductible tax loss. Taxable income is generally tied to positive spreads or to gains/losses on a later sale.

Q: Can my company reprice options without shareholder approval? A: It depends on the plan and corporate governance. Many repricings require board approval and sometimes shareholder approval, particularly if shares are exchanged or if the repricing materially affects shareholder rights. Consult your company counsel or plan administrator.

Q: What if my options are about to expire? A: If options are expiring and they are underwater, exercising just to preserve them rarely makes sense economically. Consider negotiating an extension, repricing, or replacement awards with your employer, and get tax/ legal advice before acting.

Q: Are there special rules for ISOs and AMT I should know? A: For ISOs, a positive spread at exercise can trigger AMT. If underwater, there is no AMT preference from exercise. AMT is complex; run scenarios with a tax professional.

Q: Can I use a broker or third‑party loan to exercise in a private company? A: Third‑party financing is more common for public companies. For private companies, lenders may require company consent, and transfers may be restricted by the company’s capitalization table and transfer agreements.

Example scenarios (worked examples)

Example 1 — Public company underwater option

Strike price: $50 per share
Current market price: $35 per share
Decision: Exercising at $50 creates an immediate $15 per share economic loss compared with buying on market. Tax rules do not grant a deduction for paying more than market at exercise. Recommendation: do not exercise; consider waiting or negotiating with employer.

Example 2 — Private company, early exercise consideration

Strike: $2 per share
Latest 409A FMV: $1.50 per share (underwater)
Consideration: If you can early exercise to start long‑term capital gains holding period and you expect a near‑term liquidity event, paying $2 now may be sensible for tax timing if you can afford the cash and accept illiquidity. But there is downside if the company does not recover.

Example 3 — Repricing and employee exchange

Employer offers option‑for‑option exchange: employees surrender underwater options (strike $30) for new options with strike $15 and new vesting schedule.
Implications: This requires board approval, may need shareholder approval, triggers accounting expense for incremental fair value, and possibly tax considerations if structured improperly. Employees should ask about vesting, treatment of prior grants, and any new tax withholding.

Final recommendations and next actions

Start by asking: can you exercise underwater stock options under your plan? Read the award documents and contact HR or the plan administrator.
If you are an employee at a public company, avoid exercising underwater options unless there is an unusual contractual reason.
If you are at a private company, gather the latest 409A valuation, understand repurchase rights, and model scenarios including the cash requirement and liquidity timeline.
Always consult a qualified tax advisor and, where appropriate, securities counsel before exercising or agreeing to exchanges or repricings.

Further explore Bitget resources if your compensation includes tokenized or blockchain‑native instruments: Bitget Wallet offers secure custody, and Bitget services can support conversion and trading where regulatory rules permit. For company equity (traditional ISOs/NSOs), use the decision checklist above and reach out to professional advisors.

More practical help: if you want, request a short personalized checklist or a sample exercise calculation for your award (provide strike, FMV, ISO/NSO type, vesting status, and expiration) and we can walk through the numbers together.

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