The client is a 50-year-old executive at a medical-devices company. He planned on using his company stock options valued at $3.5 million to support him and his wife in retirement, and to help pay for their children’s college educations.
His advisor, Lynn Chen-Zhang, wanted him to begin exercising his options, selling the underlying stock and diversifying the proceeds, but the man wasn’t eager to make any moves. Diversification didn’t seem important to him, and he was tempted to wait until the options’ were about to expire before exercising them.
So Ms. Chen-Zhang illustrated the importance of diversifying stock options using the StockOpter leverage table. In 1999 she watched a client lose close to $5 million in employee stock option value when his technology company collapsed so she now shows clients what happens to the value of their options if the company stock price falls significantly.
“When you just talk about diversifying, executives will nod their head like they understand, but once you’re done they’ll stop thinking about it,” says Ms. Chen-Zhang, a partner at Zhang Financial, which manages $2 billion for 1,000 clients in Portage, Mich. “That’s why it’s important to find a way to make them visualize the risk.”
In this case and using the following analytics from StockOpter.com, she asked her client to imagine what would happen if his company stock declined 20% from its current price of approximately $96. This was a realistic possibility, because a year before the shares had traded for $77.
She then reminded the client that stock options have a fixed exercise price which means a falling stock price has greater impact on the value of those options than it does on individual shares of the stock. For example, if the company’s stock price fell by 20%, the value of the client’s options would fall by 47%, to $1.8 million.
Ms. Chen-Zhang continued the discussion by showing her client what would happen if the shares fell another 20% to $61, the stock price in 2013. In that scenario, his options would be worth $700,000, an additional 61% decrease in value.
To drive the point home, the adviser showed the effects of another 20% drop to $49, the stock’s 2011 price. If this happened, and historical share prices showed that this could be a real possibility, the client’s options would be worth less than $150,000.
The adviser closed her argument by explaining that the leverage effect inherent in stock options, due to the fixed exercise price, makes them more volatile than holding the stock itself. “With stocks you can just hold on to it until it goes back up,” she says. “But options expire so the leverage effect has to be factored into the decision.”
The client saw how easily he could lose the wealth he was counting on to fund his retirement and children’s educations. He agreed to allow Ms. Chen-Zhang to begin exercising the options, selling the shares, and reinvesting the proceeds in a diverse mix of stocks and bonds.
Ms. Chen-Zhang notes that it can make sense for an executive to retain options when a company’s stock appears to be undervalued and there are several years left before those grants expire. However, if the expiration date is nearing, she recommends that her clients exercise and diversify at least a portion of the options to reduce risk. And because many executives have much of their wealth tied up in options, it’s critical to show them the numbers.
“I use StockOpter’s leverage table because I needed a way to help executives see the very real need for diversification” Ms. Chen-Zhang says.