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- FAQs – Stock Options
- A word about secondary markets
- What Happens to Stock Options When One Company Is Bought by Another? | Pocketsense
- Fallacy 1: Stock Options Do Not Represent a Real Cost
- For the Last Time: Stock Options Are an Expense
You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost.
The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money i. It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.
Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time.
LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration.
FAQs – Stock Options
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables.
For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration.
With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices.
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If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm. If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration.
While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. For all listed options in the U. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday. Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own shares through the automatic exercise feature. Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short shares through the automatic exercise feature.
Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration. With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options. With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices.
In the mids, an options backdating scandal in the U. This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder. Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days.
Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer.
As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions.
A word about secondary markets
However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining.
As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs. With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance.
What Happens to Stock Options When One Company Is Bought by Another? | Pocketsense
But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock. You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock.
In addition to your ESOs, if you also have a significant amount of company stock in your employee stock ownership plan ESOP , you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA. Understanding the interplay of these variables—especially volatility and time to expiration—is crucial for making informed decisions about the value of your ESOs. The first table below uses the Black-Scholes option pricing model to isolate the impact of time decay while keeping volatility constant, while the second illustrates the impact of higher volatility on option prices.
You can generate option prices yourself using this nifty options calculator at the CBOE website. As can be seen, the greater the time to expiration, the more the option is worth. Since we assume this is an at-the-money option, its entire value consists of time value. The first table demonstrates two fundamental options pricing principles:. This increase in volatility has a significant effect on option prices.
Similar results are obtained by changing the variables to levels that prevail at present. The key takeaway from this section is that merely because your ESOs have no intrinsic value, do not make the naive assumption that they are worthless. Because of their lengthy time to expiration compared to listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise. As discussed in the preceding section, your ESOs can have significant time value even if they have zero or little intrinsic value.
In this section, we use the common year grant term to expiration to demonstrate the risk and reward associated with owning ESOs.
Fallacy 1: Stock Options Do Not Represent a Real Cost
As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise.
In fact, your ESOs have the highest time value at grant assuming that volatility does not spike soon after you acquire the options. With such a large time value component—as demonstrated above—you actually have value that is at risk. This loss of time value should be factored in when computing your eventual return. Before we look at some of the issues surrounding early exercise—not holding ESOs until expiration—let's evaluate the outcome of holding ESOs until expiration in light of time value and tax costs.
Below shows after-tax, net of time value gains and losses at expiration. As a way to reduce risk and lock in gains, early or premature exercise of ESOs must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks.
When an ESO is granted, it has a hypothetical value that—because it is an at-the-money option—is pure time value. This time value decays at a rate known as theta, which is a square root function of time remaining. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way although not proportionately. The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim.
For the Last Time: Stock Options Are an Expense
As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for a deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill. We cannot emphasize this point enough—the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it.
If you sell immediately upon exercise, you have locked in your compensation "gains" the difference between the exercise price and stock market price. But if you hold the stock, and then sell later on after it appreciates, you may have more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your "basis price.
To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes—compensation and capital gains. Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates.
You now decide to sell one-half your holdings of 1, shares and keep the other half for potential future gains. To summarize:. Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock. That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations:.
We discuss some basic ESO hedging techniques in this section, with the caveat that this is not intended to be specialized investment advice. We strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager. We use options on Facebook FB to demonstrate hedging concepts. For reference, the Jan. To keep things simple, we assume that you wish to hedge the potential share long position to just past three years i.
Of these strategies, writing calls is the only one where you can offset the erosion of time value in your ESOs by getting time decay working in your favor. Buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk, while the costless collar has minimal cost but does not resolve the issue of ESO time decay. ESOs are a form of equity compensation granted by companies to their employees and executives. ESOs are not the only form of equity compensation, but they are among the most common. Stock options are of two main types.
Incentive stock options, generally only offered to key employees and top management, receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains. Non-qualified stock options NSOs can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such.