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, I believe it’s important to understand what leverage is and the significant impact it may have on your wealth.

What is leverage?

In this piece, we are referring to share leverage, something implicit in options and different from leverage involving borrowed funds to invest. Share leverage essentially means that the value of your options increases or decreases at a greater rate than the stock itself.

Consider the following example:

• You have 1,000 option shares 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:

• Option Value = (Current Stock Price - Option Price) x Number of Shares

Source: CI Private Wealth

Now let’s look at how share leverage may impact the option value. Notice the percent change in option value versus the stock value (yellow highlight) as the stock price increases or decreases:

Change in Stock Price vs. Value of Options

Source: CI Private Wealth

If the stock value increases by only another 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 we/I believe stock options have tremendous upside potential.

Leverage also works on the downside. A 5% drop in stock value in this example results in a 55% decrease in option value.

Notice that the option value is zero if the stock falls 10%. Why? In this instance, the current 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 value is zero. (These options cannot be worth less than zero.)

I find it’s important to remember that in order for your 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 when the difference between the current stock price and the option price grows larger. The option value tends to increase or decrease more in lockstep with the percentage change of the actual stock price. Consider the same example, except the current stock price is $550 versus $55.

Change in Stock Price vs. Value of Options

Here you see that if the stock price increases by 5%, the value of the options increases by only 6%. In general, I believe 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.

As we’ve said before, 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

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