Stock Options and Leverage: The Power to Build or Diminish Wealth
“Leverage is a double-edged sword that enhances returns in good times while sinking them in down markets,” Seth Klarman1
If you hold employee stock options, we believe it’s important to understand what leverage is and the significant impact it may have on your wealth.
What is leverage?
In this article, we are referring to share leverage, which is a normal part of stock options and different from the leverage involved in borrowing funds to invest. Share leverage essentially means that the value of your options increases or decreases at a greater rate than the value of the stock itself.
Consider the following example:
- You have 1,000 options with an option price of $50. This means you have the right to buy up to 1,000 shares of company stock at $50 over a set period (typically 10 years).
- Let’s assume the stock now trades at $55/share.
- Your gross option value is $5,000:
| Shares Granted | Option Price | Value = $55.00 | Total Cost | Option Value |
|---|---|---|---|---|
| 1,000 | $50.00 | $55,000 | ($50,000) | $5,000 |
- Option Value = (Current Stock Price − Option Price) x Number of Shares
Now let’s look at how share leverage may impact the option value. Notice the percent change in the option value versus the stock value (yellow highlight) as the stock price increases or decreases:
| Change in Stock Price vs. Value of Options | ||||||
|---|---|---|---|---|---|---|
| % Change in Stock Price | -10% | -5% | Current | +5% | +10% | +20% |
| Stock Price | $49.50 | $52.25 | $55.00 | $57.75 | $60.50 | $66.00 |
| Option Value (1) | $ - | $2,250 | $5,000 | $7,750 | $10,500 | $16,000 |
| % Change in Option Price | -100% | -55% | +0% | +55% | +110% | +220% |
If the stock value increases by 5%, the option value increases by 55%. A 20% increase in stock value results in a 220% increase in the option value! This example illustrates why stock options can have tremendous potential. However, leverage also works on the downside. In this example, a 5% drop in stock value results in a 55% decrease in option value—a loss of more than half its value.
Notice that the option value is zero if the stock falls just 10%. Why? In this instance, the stock price ($49.50) is less than the option price ($50.00). There is no advantage to exercising and buying the stock at $50/share when it’s only worth $49.50/share on the open market. Therefore, the option has no value.
We think it’s important to remember that, for your company stock options to have any value, the stock price must increase after your options are granted. If it doesn’t, your options hold no value. In addition, the company does not need to go bankrupt for your options to become worthless. The stock price only needs to fall below the option price.
When leverage diminishes
Leverage will decrease as the difference between the current stock price and the option price grows larger. As this occurs, the option value will tend to increase or decrease in lockstep with the percentage change of the stock price. Consider the same example, except with a current stock price of $550 versus $55.
| Change in Stock Price vs. Value of Options | ||||||
|---|---|---|---|---|---|---|
| % Change in Stock Price | -10% | -5% | Current | +5% | +10% | +20% |
| Stock Price | $495.00 | $522.25 | $550.00 | $577.50 | $605.00 | $660.00 |
| Option Value (1) | $445,000 | $472,500 | $500,000 | $527,500 | $555,00 | $610,000 |
| % Change in Option Price | -11% | -6% | +0% | +6% | +11% | +22% |
Here you see that if the stock price increases by 5%, the value of the options increases by only 6%. In general, we believe that to maximize upside value, you should exercise options with the least amount of leverage first.
Other considerations
Leverage is only one of many factors to consider regarding stock options. Time to expiration, taxes and the exposure you have to your company stock are also important considerations. If your options have high leverage but are approaching expiration, leverage becomes less of a factor. If the bulk of your wealth comes from options and you can meet your goals by locking in today’s value, it may be prudent to do so.
Exercising stock options can be more of an art than a science and often comes down to your goals in the context of your overall financial plan. Running the numbers to see your plan’s dependency on such factors may help you make the best decisions possible.
1 http://mastersinvest.com/leveragequotes
ABOUT THE AUTHOR
Gary Pattengale, CPA, CFP
Gary is a Wealth Advisor in our Itasca, IL, office. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.
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