Employee stock options are different from other investments. Deciding when best to exercise them can be a daunting task. For employees who own stock options, one of the most important factors is leverage. Sometimes a difficult concept to grasp, leverage can have a significant impact on your overall financial picture, so it’s important to understand it.
What exactly is leverage as it relates to stock options?
In a nutshell, as the price of an underlying stock increases, the value of the option to buy that stock may be increasing at a higher rate—that difference, or spread, is leverage. To illustrate the impact of leverage, let’s assume you have 10,000 employee stock options with a grant (or “strike”) price of $80/share and a current market value of $100/share.
Stock Option Value = 10,000 x ($100-$80)
=$200,000
As the stock price increases, so does the value of your options. That’s easy to understand. However, what is not so intuitive is that the value of the stock options is increasing at a faster pace than the price of the stock, as illustrated below.
| Stock Price | % Change in Stock Price | Value of Stock Options | % Change in Value of Stock Options |
|---|---|---|---|
| $100.00 | 0% | $200,000 | 0.0% |
| $110.00 | 10% | $300,000 | 50.0% |
| $121.00 | 10% | $410,000 | 36.7% |
| $133.10 | 10% | $531,000 | 29.5% |
| $146.41 | 10% | $664,100 | 25.1% |
| $161.05 | 10% | $810,510 | 22.0% |
| $177.16 | 10% | $971,561 | 19.9% |
| $194.87 | 10% | $1,148,717 | 18.2% |
| $214.36 | 10% | $1,343,589 | 17.0% |
In the example above, a 10% increase in the stock price from $100 to $110 per share results in a 50% gain in your stock options value, which is a result of leverage.
But, critically, those superior proportionate gains diminish as the stock price goes up. The impact of leverage on the upside is reduced the further the stock price increases from the strike price.
Like many financial situations, there can be a “sweet spot”—where the upside potential is decreasing, and the downside potential is increasing.
In another example, if you were to own the same options, but the current price was already at $146.41, you’ll see the impact leverage has on the downside as the stock price falls.
| Stock Price | % Change in Stock Price | Value of Stock Options | % Change in Value of Stock Options |
|---|---|---|---|
| $77.81 | -10% | – | -100.0% |
| $86.45 | -10% | $64,536 | -59.8% |
| $96.06 | -10% | $160,596 | -39.9% |
| $106.73 | -10% | $267,329 | -30.7% |
| $118.59 | -10% | $385,921 | -25.5% |
| $131.77 | -10% | $517,690 | -22.0% |
| $146.41 | 0% | $664,100 | 0.0% |
| $161.05 | 10% | $810,510 | 22.0% |
| $177.16 | 10% | $971,561 | 19.9% |
| $194.87 | 10% | $1,148,717 | 18.2% |
| $214.36 | 10% | $1,343,589 | 17.0% |
It’s easy to fall into the trap of watching the price increase for the stocks on which you hold options, and imagining your potential gains are increasing at the same rate. As we hope these examples clearly show, they are not.
There’s no right answer to this issue. The price at which you decide to exercise your employee stock options is set by individual considerations and can be tough to gauge. But understanding how to interpret the different factors, such as the power of leverage, can help you make an informed decision.
Please don’t hesitate to contact us for advice.
The Bridgewater Team.