If you currently or have ever worked for a large company, there is a good chance that you’ve received stock options as part of your compensation package. These can be a great way to enhance your overall savings and are a very nice benefit to have! Many people consider their stock options to be the same as owning the company stock outright, however that might not be the best way to think about them.
Employee stock options are a great benefit, allowing people to directly participate in the success of the company they work for. However too often people consider these options the same as owning the company stock outright, which may mask advantages or certain risks associated with holding the options portfolio.
The most common misunderstanding (and the one we’ll cover today) that we’ve come across with employee stock options is the leverage embedded in them. Most people assume the value of their options portfolio increases and decreases exactly the same as a portfolio which simply holds the stock, however this is rarely true. When you own stock options the value of your holdings will often increase (or decrease) more than the value of the shares themselves. It’s not very intuitive so let’s walk through an example.
Say you own 100 options of ABC Co. with a strike price of $100/share and the current price is $200/share. The value of your options portfolio will be (Current price – Strike price) * # of options, or in this specific case ($200 – $100) *100 = $10,000. Now let’s say the stock price of ABC Co. increases to $400/share, or a return of 100%, what is your options portfolio return? Let’s walk through the formula again, ($400 – $100) *100 = $30,000! A 100% increase in the share price resulted in a 200% increase in your options portfolio! That’s a part of employee stock options that a lot of people overlook, they’re a levered bet on the stock. We can create a table to see how different changes in the stock price result in amplified (levered) values of the stock option portfolio.
|Stock Price||% Change in Stock Price||Stock Option Portfolio Value||Change in Stock Option Portfolio Value||% Change in Stock Option Portfolio Value|
|$ 200.00||$ 10,000.00|
|$ 220.00||10%||$ 12,000.00||$2,000||20.00%|
|$ 242.00||10%||$ 14,200.00||$2,200||18.33%|
|$ 266.20||10%||$ 16,620.00||$2,420||17.04%|
|$ 292.82||10%||$ 19,282.00||$2,662||16.02%|
|$ 322.10||10%||$ 22,210.20||$2,928||15.19%|
|$ 354.31||10%||$ 25,431.22||$3,221||14.50%|
For each 10% increase in the stock price the options portfolio grows by a multiple of that. Astute readers will notice something else in the table. As the stock price moves further and further away from the strike price the amount of leverage decreases. This is illustrated by the descending values in the last column. As the leverage in the stock options portfolio decreases the performance becomes more like owning the stock outright and can often be used as a barometer of when to exercise the options. Put another way if there’s very little leverage left, you’re nearing expiration, and you’re willing to pay the IRS the taxes due on the options gains, you may want to consider exercising.
As you can see in the example employee stock options can be a great way to supplement your savings and can boost returns to your overall portfolio due to the leverage embedded in the options. However, the leverage works the same way if the price of the stock decreases so this always must be considered when creating your overall allocation. In addition to the leverage embedded in the options another risk is that you’re allocating to one individual company’s stock and if you receive multiple grants of employee stock options over the years, they could wind up becoming a very large part of your portfolio. This risk is amplified further by the fact that environments that could lead to a sharp decline in the company stock might also create a situation where the company is laying employees off, etc.
We hope this post can help provide a framework for thinking about any company stock options you may hold and as always if you have questions regarding any employee stock options you might hold, please feel free to reach out to us, we’re happy to help!
Your Team at iNNOVA Wealth Partners
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