by Kaye A. Thomas
A good understanding of option value can help the option holder appreciate this important benefit more fully. Armed with this knowledge, the option holder is more likely to adopt a good strategy and avoid common mistakes.
It’s not all rocket science
At one level, option value is a highly technical subject. You aren’t likely to understand the mathematics of the Black‐Scholes formula, used to calculate option value, unless you’re a rocket scientist, or at least a whiz at multivariable calculus and differential equations. Yet the most important features of option value are not difficult to grasp, and while some of the principles may seem counterintuitive at first, they ultimately rest on common sense.
Two kinds of value
A stock option has two kinds of value, one being obvious and the other somewhat elusive. The obvious part of an option’s value arises when the stock trades at a price higher than the exercise price of the option. If the option lets you buy shares at $20, and the stock is currently trading at $25, it’s easy to see that you would have a profit of $5 per share if you exercise the option and immediately sell the shares at the current price. The technical term for this element of option value is intrinsic value, but a friendlier term might be cash value, meaning the amount of profit you would realize if you cashed in the option based on today’s stock price.
Some option holders act as if cash value is the entire value of the option, or at least the only element of value worth considering. Yet it is equally important to understand time value, which is the value of the opportunity to continue holding the option (rather than cash it in today). This may seem like an abstract concept, but we can illustrate it with a simple example.
Example: You received an option to buy 1,000 shares of your company’s stock at $20.00 per share. The stock is currently trading at $20.10. You expect to be able to continue holding the option another five years if you don’t cash it in sooner.
You can’t sell an employee stock option, but let’s suppose you could. Would you accept $100 for this one? That’s the current cash value, so this question is equivalent to asking whether it would make sense to cash in the option for this much profit.
This is an easy question. Continuing to hold the option places the $100 cash value at risk, because there’s a possibility that the stock price will drop below $20.00 and stay there for the duration of the option, leaving you with no profit at all. Yet the potential profit from this option is entirely out of proportion to this potential loss. We can’t predict the future stock price, but experience with stocks in general tells us the stock could easily reach a price of $25.00 or even $30.00 within the next five years, giving you a profit of 50 to 100 times as much as you would get by cashing in today. The benefit of protecting the current cash value of $100 is small compared with the potential profit from continuing to hold the option.
Option value is not a prediction
Let’s suppose a Black‐Scholes calculation has been done for the option described above, and it gives us a value of $6.10 per share. We can see that the cash value is $0.10 per share, so the formula is indicating a current time value of $6.00 per share. But what does the value of $6.10 per share really represent? Does it imply that you should expect an eventual profit of $6.10 per share if you continue to hold the option?
Certainly not. Your eventual profit will depend on the value of the stock when you cash out, and no one can tell what that will be, with or without a fancy mathematical formula. Yet this figure provides useful information. Roughly speaking, it represents an average outcome from holding an option with these characteristics. You might compare it to the information that the average total when rolling a pair of dice is seven. This isn’t a prediction of the total you’ll get on a particular roll. It isn’t even an estimate. An individual outcome may be nowhere near this figure. This is merely a statistical average. Option value is not a prediction or even an estimate.
Using option value
Although you can’t rely on option value as a prediction, it can help you make an informed choice about how to handle your option. In the example above, we see that the average outcome of holding the option is 60 times larger than the outcome of cashing in today. This makes it clearer than ever that it would be a mistake to cash in for this small profit.
Compare a very different situation in which you hold an option with $10.00 per share of built‐in profit. We’ll assume the option is close to expiration, and the total value of the option is now $10.50 per share, indicating a remaining time value of $0.50 per share. You would forgo the opportunity for an added profit, with a statistical average of $0.50 per share, if you cash in now. Depending on your personal circumstances, this might be a reasonable choice, as the opportunity to protect the existing profit of $10.00 per share from fluctuations in the stock price may be more important than the chance to increase that profit by continuing to hold the option.
How time value changes
Most option holders don’t have ready access to a professional valuation of the options they receive from their employer. An understanding of how time value changes can often give you enough information for an informed judgment, however.
One important principle is that time value is always a fraction of the exercise price of the option. While the figure may vary depending on the characteristics of the option and of the stock of the company that issued the option, a crude but reasonable figure for a newly granted option might be 30% of the exercise price. This figure assumes the option will vest and that you’ll be able to hold it at least five years if you choose to do so.
Now suppose the stock value doubles. You hold an option at $20 to buy shares that are currently trading at $40. We’ll assume the option still has at least five years to run. We can easily see that the cash value of the option is now $20 per share. What has happened to the time value? Did it rise proportionately with the cash value?
On the contrary, the time value has become smaller. If the time value was $6 per share when the option was issued, it’s likely less than $3 per share now. Let’s take a closer look at time value to see why this happens. We’re going to compare the economic consequences of two courses of action: (1) you continue to hold the option, exercising it only when it is close to expiration, and (2) you exercise the option now, and then hold the stock until the time when you would otherwise cash in the option.
Continuing to hold the option is economically preferable in two ways. If you exercise the option today, you have to pay the exercise price now. Continuing to hold the option permits you to postpone that payment. This feature of the option provides you with the economic equivalent of an interest‐free loan. This element of time value is unchanged when the stock price increases, because the dollar amount of the exercise price you’re postponing remains unchanged.
The other element of time value is usually more important. It derives from the fact that we aren’t able to predict the price of the stock. It’s possible that at the time when the option is set to expire, the stock value will be less than the exercise price of the option. In this unhappy event you will allow the option to expire unexercised, having failed to secure any profit from it. In the comparable situation where you have exercised the option and held the shares, however, your result would be even worse. Instead of merely forgoing profit, you would incur a loss. The main source of value in an option springs from the opportunity to profit from an increase in stock value without risking loss in a decline.
Now let’s return to the situation where your exercise price is $20 and the stock is trading at $40. Recall that we’re comparing the economics of holding the option with exercising now and holding the stock. The option still protects you against a decline in the price of the stock below $20— but because the stock is now trading at $40, a future price below $20 is far less likely. The value of this downside protection isn’t zero, but it’s far smaller than when the stock was trading near the $20 exercise price.
The upshot is that when an option is deep in the money, meaning the exercise price is small in relation to the current trading price of the stock, the time value of the option may be small in relation to its overall value, even if the option has several years left until expiration.
Options under water
When the stock trades below the exercise price of the option we say the option is under water. You don’t need to think much about the strategy for handling this option. The only thing to do is wait for a rebound that will allow the option to produce a profit.
It’s useful to understand how time value works for an option that’s under water, however. Many option holders believe the option has little or no value, even if the option won’t expire for several years. This impression may be due in part to a mistaken view that a stock that has recently fallen in price is unlikely to rise in the near future. In reality, the recent price performance of a stock offers no reliable clue to its future course.
While a decline in stock value below the exercise price of an option is not a favorable development, an option may retain considerable time value despite being under water. Price fluctuations are a normal occurrence in the stock market, and recovery from a downswing happens more often than not. In the world of stock investing, patience pays.
We can draw the following general conclusions, subject always to the caveat that individual circumstances may justify different approaches.
- When you exercise an option that isn’t about to expire, you abandon the option’s remaining time value.
- For an option that is only slightly in the money, time value is likely to be much larger than the profit that can be secured by cashing in the option In this situation it’s generally better to continue holding the option.
- When the stock price rises far above the exercise price of the option, the time value of the option may become a small fraction of the cash value, even if the option will not expire for several years. Depending on your investment objectives, it may make sense to consider cashing in at least part of the option.
- Except in extreme cases, an option may retain substantial value in spite of a stock price that has fallen below the option’s exercise price. There is no reason to be dissatisfied or discouraged, as price fluctuations are normal and the option may yet produce the profit for which you are hoping.
Kaye A. Thomas is a lawyer, consultant, and author of books dealing with equity compensation, taxation and investments, including Consider Your Options (for recipients of equity compensation), Equity Compensation Strategies (for professionals who provide advice to recipients of equity compensation), and Capital Gains, Minimal Taxes. He maintains a website at www.Fairmark.com.