With Stock Options, Leverage Can Build or Diminish Wealth
When executives receive stock options as part of their compensation package, they must be aware of the role leverage could play in adding to or detracting from their value.
“Leverage is a double-edged sword that enhances returns in good times while sinking them in down markets.” Seth Klarman1:
Corporate executives are often granted stock options related to their company’s shares. In many cases, such options may form a large component of their overall compensation package. If you hold employee stock options, we believe it’s important to understand what leverage is and the significant impact it may have—positive or negative—on your wealth.
What is leverage?
In this article, we’re referring to share leverage, which is a normal part of stock options and quite 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 hold 1,000 share 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 per share.
- Your gross option value is $5,000, as calculated below:
| Shares Granted | Option Price | Value = $55.00 | Total Cost | Option Value |
|---|---|---|---|---|
| 1,000 | $50.00 | $55,000 | ($50,000) | $5,000 |
| ||||
Now let’s look at how share leverage may impact the option value. Notice the percentage change in the option value versus the stock value 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’s no advantage to exercising and buying the stock at $50 per share when it’s only worth $49.50 per share on the open market. Therefore, the option has no value.
It’s important to remember that, in order 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.
When leverage diminishes
Leverage will decrease as the difference between the current stock price and the option value 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 in our previous scenario.
| 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%. Having a strategy for which options to exercise, and when, is an important element in your financial plan. Corient’s Wealth Advisors build models to develop stock option exercise strategies for our clients.
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 you hold much of your overall wealth in company stock, it could pose a “concentration risk” because this lack of diversification means you’re vulnerable to a significant drawdown in wealth if the company’s fortunes decline. If your options have high leverage but are approaching expiration, leverage becomes less of a factor as you need to exercise them in a relatively short period of time. If the bulk of your wealth comes from options and you can meet various financial goals by locking in today’s value, it may be prudent to do so.
At times, exercising stock options can be more of an art than a science, and often comes down to your objectives 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. Your Corient Wealth Advisor can assist you with the calculations and your ultimate decisions regarding your stock option compensation.
1 http://mastersinvest.com/leveragequotes
ABOUT THE AUTHOR
Lisa Brown
Lisa is a Partner, Wealth Advisor in our Atlanta office. She joined legacy firm Brightworth in 2005 and became a Partner in 2010. In addition to working with clients, Lisa has published three books: Girl Talk, Money Talk. The Smart Girl’s Guide to Money After College; Girl Talk, Money Talk II. Financially Fit and Fabulous in Your 40s and 50s; and legacy firm Brightworth’s first book, Building Your Wealth Inside Corporate America. Lisa has been featured in The New York Times, The Wall Street Journal, YahooFinance, CNBC.com, and many more, and frequently speaks at seminars across the country.
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5096027 – January 2026
