General Forum

Attempt at some answers

Posted By: Don Schlesinger
Date: 15 Aug 01, 8:13 am

In Response To: 1 investment question (Fezzik)

"Many employees now are being granted stock options that have 5 or 10 year expirations, and strike prices equal to starting price."

I'm hoping that what you mean by this is that the options are issued "at the money," with strike price equal to the current stock price, on the date of issue of the options. Is that what you meant?

"Just for fun, let's use Joe Q Public

Age 40

Assets: $50,000

Annual Income: $50,000

Options granted: 200 per year, 10 year window

Price: 1997-2001: 100 (the stock has bounced up and down but been at 100 boy????? each year)."

Again, I'll guess what you mean is that the strike price of all the options is 100, because, for the sake of simplicity, that's where the stock always seems to wind up when the options are granted.

"So our hero now has 1000 options. The stock soars in 2001 to 150. No one has any idea what it will do in the future."

OK.

"Many [employ?]ees are (or were during the bull market) facing this dilemma."

There are worse dilemmas to be facing in the stock market these days!

"A good percentage of them were cashing all (100%) of their options out for the quick 50k."

In fact, with a quick run-up, most employees are not able to do what you describe. Most such options are granted as "restricted," with a mandatory holding period before they can be liquidated. I have such ten-year options. In my case, they were not exercisable until after the first five years, and this is a typical arrangement.

In any event, we'll assume, for your example, that the employees may, indeed, exercise at any time and receive only the intrinsic value of the options (the current stock value minus the strike price), thereby forfeiting all remaining time premium.

"I was always one to roll the dice and run 'em long."

No! I can't imagine! Never would have guessed that! :-)

"In fact, I was shocked at how afraid people were to be rich. They would rather grab a small payout, get smashed on taxes, and then buy a car, rather than roll forward with a huge future PV, even with great risk."

There's much more to it than that. There's the alternative minimum tax, and some people have gotten destroyed with what they owe, even as the options have sunk to "underwater" status. There are some very sad stories out there. For others, a meteoric run-up in something like a dot-com has been followed by a horrific bust, with the stock losing 90-95% (if not 99%!) of its value. Those who cashed their options early are the only ones left unbloodied.

I can only repeat the fundamental tenet of Wall Street: No one ever went broke taking a profit.

"Of course, this example is much different from the decision to sell a stock, since the deferred value of the option is so much higher as the stock appreciates."

Not sure what you mean by this. Most stock options that are granted as compensation can not be "sold" in the normal sense of the word. That is, the Black-Scholes model alone won't give you their true value, since, when exercised, by definition, you can never get anything more than intrinsic value for them. So, if the options are not deep in the money, they have a good deal of "time value" (probably what you mean by "deferred value"), which can't ever be realized when you exercise. This is NOT the case with "normal" options. And so, that is why, in most cases, it isn't such a good idea to exercise too early.

On the other hand, if the stock is much higher than the strike, and the options are very much in the money, then, for all intents and purposes, they are stock and appreciate dollar-for-dollar with the underlying. For example, I currently own options with an (adjusted for splits) strike price of $9 (with the stock currently at $56). That stock also traded, within the last year, at $110! And, no, I haven't exercised any options yet . . . but I very strongly wish that I had!

"However, I am curious as to your opinion. If the B.Scholes pricing model, for example, using reasonable assumptions"

As opposed to using it incorrectly by inputting unreasonable assumptions??! (Just busting your chops a little.)

"calculated the value of the options at say 120k vs. the 50k you could realize, would you look to sell any of the options?"

Your assumption isn't realistic. Assuming a stock at 150, with a strike of 100, 4% annual risk-free rate, five years to maturity and, say 30% volatility (annualized standard deviation of the continuously-compounded returns), the options are worth $75 (by B-S standards). So, 1,000 of them are worth $75,000. If we have a full ten years to go, the option is still worth only $92. Once options get very deep in the money (the delta of the 5-year option is already 89.2%), they shed most of their time premium.

"Obviously, a full payout is silly. I wouldn't sell any unless I was absolutely forced to come up with money for an emergency."

Your viewpoint is understandable, because leaving, say, a third of the options' B-S value on the table by exercising is somewhat upsetting. But so is watching a $110 stock go to $44, or a $220 dot-com go to zero!!

"This question is already twice as long as I wanted it to be!"

This answer is already about five times as long as I thought it would be! :-)

Don

Messages In This Thread

How to handle the "huge exposure game" -- Fezzik -- 12 Aug 01, 11:53 pm

So, will you be hedging against the Mariners in October? -- James -- 13 Aug 01, 12:33 am

Difference between A's and Eagles -- StevieY -- 13 Aug 01, 11:35 am

that's not a hedge -- docriver -- 13 Aug 01, 12:10 pm

Yes and no -- StevieY -- 13 Aug 01, 12:33 pm

risk -- docriver -- 13 Aug 01, 1:04 pm

Hedging -- StevieY -- 13 Aug 01, 1:38 pm

Example please? -- docriver -- 13 Aug 01, 1:56 pm

Example -- StevieY -- 13 Aug 01, 5:36 pm

because you have 40x in equity now -- docriver -- 13 Aug 01, 6:01 pm

above title should read : 18x, not 40x (nt) -- docriver -- 13 Aug 01, 6:08 pm

You aren't wagering 18,000+ -- StevieY -- 13 Aug 01, 6:11 pm

Agree to disagree -- docriver -- 13 Aug 01, 6:20 pm

You are both right, even disagreeing -- Fezzik -- 15 Aug 01, 1:32 am

Size your bets according the payoff, not the bet size. -- Stanford Wong -- 13 Aug 01, 6:39 pm

he really has found some arbitrage -- Math Boy -- 13 Aug 01, 8:21 pm

You can always overbet if the marginal EV from betting more is less than th -- docriver -- 13 Aug 01, 8:41 pm

Practical issues -- James -- 14 Aug 01, 11:27 am

i'm the minority -- docriver -- 13 Aug 01, 8:38 pm

hedging futures bets -- rainmandon -- 21 Aug 01, 7:51 pm

I understand the bet... -- StevieY -- 21 Aug 01, 7:58 pm

hedging futures -- rainmandon -- 21 Aug 01, 9:22 pm

I understand the bet... -- StevieY -- 22 Aug 01, 6:40 pm

Sea hedge -- Fezzik -- 15 Aug 01, 1:34 am

Oops.......I showed my Sea Bias -- Fezzik -- 15 Aug 01, 1:36 am

I'm in the same boat. I won't hedge. -- Stanford Wong -- 13 Aug 01, 8:57 am

Risk-averse betting? -- John May -- 13 Aug 01, 9:14 am

Agree -- Don Schlesinger -- 14 Aug 01, 1:11 pm

1 investment question -- Fezzik -- 15 Aug 01, 2:29 am

Attempt at some answers -- Don Schlesinger -- 15 Aug 01, 8:13 am

how much does money mean to you? -- docriver -- 15 Aug 01, 8:39 am

In-the-money options -- Jaeger -- 23 Aug 01, 6:44 pm

No -- Don Schlesinger -- 23 Aug 01, 8:55 pm

Risk-averse betting? -- lepto -- 14 Aug 01, 1:33 pm

Your bet suffered turf toe -- McNabb#1 -- 14 Aug 01, 4:24 am

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