A lever works by reducing the amount of force required to move an object by increasing the distance through which the force acts. In the world of investing, leverage appears everywhere and is the act of using “borrowed” financial instruments (the lever) to increase the return on an investment.
In our case, the fixed exercise price of the shares you have been granted, (but do not yet own outright) is the lever. The potential return is any increase in the underlying stock’s price beyond that grant price. While leverage can result in faster growth of an investment, it is also a two-way street. With increased potential for return, always comes a commensurate addition to the risk involved. For this exercise, we will examine the potential downside risk of leverage associated with ownership of stock options.
Blake, an employee of XYZ corporation, was granted one hundred option shares at a strike price of $35/share back in 2018. Those shares have now fully-vested and XYZ corporation stock has since moved all the way up to $100/share. However, Blake believes that $100 is not high-enough. With how things have been going at the company over the past few months, he expects the stock to go much higher in the not-so-distant future. With this in mind, Blake chooses to delay the exercise of his granted shares.
Unfortunately, soon after this decision, one of XYZ’s flagship products suffers a catastrophic failure and they are forced to recall a majority of the product. Consequently, the stock price drops 50%. Below is an illustration of the impact of this price drop on both Blake’s option shares and 100 shares he purchased outright at a prior date.
In this scenario, the leveraged (option) shares fare far worse than the purchased shares. The numbers don’t lie. While the value of the shares that Blake owned outright fell in-step with the price of the stock, the value of his option shares dropped much more – twenty seven percent more to be exact. But why? In simplest terms, option shares have a higher threshold to become valuable. While shares owned outright have value all the way down to a $0.01 stock price, the floor value for a stock option is its grant price. At the point where XYZ corporation’s shares dip below Blake’s $35 grant price, the options are worthless.
While there are many factors to consider when deciding whether to exercise stock options, the effect of the potential change in value due to price fluctuation is not to be ignored. Senior executives often have a significant portion of their net worth “tied-up” in stock options and while the underlying asset may be company stock, it is vital that these option shares are not viewed in the same light as owning company stock outright. As shown in this example, their value is far more volatile.
The intent of this exercise is not to intimidate the reader, but simply to illustrate the leverage and risk inherent in options as an investment vehicle. After all, the same principle is true in reverse, a significant increase in the underlying stock price can drastically increase the value of stock options grants. As with any investment, it is critical that you understand the risks and plan accordingly.