If you own employee stock options, it’s important to understand how leverage plays a role in your financial picture. What is leverage? Simply put, if you own stock options and the value of the underlying stock goes up by 10%, but the value of your stock options increases by 25%, you have leverage.
To illustrate leverage, assume you have 10,000 employee stock options with a grant price of $30 per share and a current market value of $50 per share. To calculate the current value of your shares, multiply the number of shares by the difference between the current price and the grant price:
Stock Option Value = 10,000 x ($50 - $30)
Using this formula, it’s easy to see that as the value of the stock increases, the number in parenthesis gets larger, and, consequently, the value of your options increases as well. What is not readily apparent, though, is that the value of your stock options – when the stock price is increasing – may actually increase by a greater percentage than the stock itself.
In the example above, a 10% increase in the price of the stock from $50 per share to $55 per share resulted in your stock options being worth 25% more. That’s leverage.
When the market is rising, leverage is a great thing. Leverage magnifies moves in the opposite direction though, too. In the same scenario, as shown above, a 10% decrease in the stock price from $50 to $45 would mean a 25% reduction in the value of your stock options!
You might also notice, as you get further down the chart, that as the stock continues to increase in value, and leverage has less of an affect. While the move from $50 to $55 increased the value of your shares by 25%, the same 10% increase from $97.44 to $107.18 only produced a 14.45% increase in the value of your shares. At this point, when the amplified return from a move higher in stock prices has eroded, it might behoove you, the shareholder, to exercise the options and reinvest the cash into a diversified portfolio.
There are many things to consider when deciding when to exercise options – liquidity needs, taxes, and expiration dates to name a few – but leverage is a powerful force and one that should factor into your decision.