Stock options details

How to Trade Options in 4 Steps

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That discourages companies from experimenting with new kinds of plans. As just one example, the accounting rules penalize discounted, indexed options—options with an exercise price that is initially set beneath the current stock price and that varies according to a general or industry-specific stock-market index. Although indexed options are attractive because they isolate company performance from broad stock-market trends, they are almost nonexistent, in large part because the accounting rules dissuade companies from even considering them.

The idea of using leveraged incentives is not new. Most salespeople, for example, are paid a higher commission rate on the revenues they generate above a certain target. Such plans are more difficult to administer than plans with a single commission rate, but when it comes to compensation, the advantages of leverage often outweigh the disadvantages of complexity.

You also have to impose penalties for weak performance. The critics claim options have unlimited upside but no downside. The implicit assumption is that options have no value when granted and that the recipient thus has nothing to lose.

But that assumption is completely false. Options do have value.

How to Trade Options in 4 Steps

Just look at the financial exchanges, where options on stock are bought and sold for large sums of money every second. Yes, the value of option grants is illiquid and, yes, the eventual payoff is contingent on the future performance of the company.

But they have value nonetheless. And if something has value that can be lost, it has, by definition, downside risk. In fact, options have even greater downside risk than stock. Consider two executives in the same company. One is granted a million dollars worth of stock, and the other is granted a million dollars worth of at-the-money options—options whose exercise price matches the stock price at the time of the grant.

The executive with options, however, has essentially been wiped out. His options are now so far under water that they are nearly worthless. Far from eliminating penalties, options actually amplify them.

What Is A Stock Option?

The downside risk has become increasingly evident to executives as their pay packages have come to be dominated by options. Take a look at the employment contract Joseph Galli negotiated with Amazon. The risk inherent in options can be undermined, however, through the practice of repricing.

When a stock price falls sharply, the issuing company can be tempted to reduce the exercise price of previously granted options in order to increase their value for the executives who hold them. Although fairly common in small companies—especially those in Silicon Valley—option repricing is relatively rare for senior managers of large companies, despite some well-publicized exceptions. Again, however, the criticism does not stand up to close examination. For a method of compensation to motivate managers to focus on the long term, it needs to be tied to a performance measure that looks forward rather than backward.

The traditional measure—accounting profits—fails that test. It measures the past, not the future. Stock price, however, is a forward-looking measure. Forecasts can never be completely accurate, of course. But because investors have their own money on the line, they face enormous pressure to read the future correctly.

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That makes the stock market the best predictor of performance we have. But what about the executive who has a great long-term strategy that is not yet fully appreciated by the market? Or, even worse, what about the executive who can fool the market by pumping up earnings in the short run while hiding fundamental problems? Investors may be the best forecasters we have, but they are not omniscient. Option grants provide an effective means for addressing these risks: slow vesting. That delay serves to reward managers who take actions with longer-term payoffs while exacting a harsh penalty on those who fail to address basic business problems.

Stock options are, in short, the ultimate forward-looking incentive plan—they measure future cash flows, and, through the use of vesting, they measure them in the future as well as in the present.

The Options Market

If a company wants to encourage a more farsighted perspective, it should not abandon option grants—it should simply extend their vesting periods. Their directors and executives assume that the important thing is just to have a plan in place; the details are trivial. As a result, they let their HR departments or compensation consultants decide on the form of the plan, and they rarely examine the available alternatives. While option plans can take many forms, I find it useful to divide them into three types. The first two—what I call fixed value plans and fixed number plans—extend over several years.

The third—megagrants—consists of onetime lump sum distributions. The three types of plans provide very different incentives and entail very different risks. With fixed value plans, executives receive options of a predetermined value every year over the life of the plan. Fixed value plans are popular today. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by compensation consultants that document how much comparable executives are paid and in what form.

But fixed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay and performance. Executives end up receiving fewer options in years of strong performance and high stock values and more options in years of weak performance and low stock values.

The stock price has doubled; the number of options John receives has been cut in half. He ends up, in other words, being given a much larger piece of the company that he appears to be leading toward ruin. For that reason, fixed value plans provide the weakest incentives of the three types of programs. I call them low-octane plans.

Understanding Your Employee Stock Options

Whereas fixed value plans stipulate an annual value for the options granted, fixed number plans stipulate the number of options the executive will receive over the plan period. Under a fixed number plan, John would receive 28, at-the-money options in each of the three years, regardless of what happened to the stock price. Here, obviously, there is a much stronger link between pay and performance.

Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases the value of future option grants. Likewise, a decrease in stock price reduces the value of future option grants. Since fixed number plans do not insulate future pay from stock price changes, they create more powerful incentives than fixed value plans.

I call them medium-octane plans, and, in most circumstances, I recommend them over their fixed value counterparts. Now for the high-octane model: the lump-sum megagrant. While not as common as the multiyear plans, megagrants are widely used among private companies and post-IPO high-tech companies, particularly in Silicon Valley.

Option (finance)

Megagrants are the most highly leveraged type of grant because they not only fix the number of options in advance, they also fix the exercise price. Shifts in stock price have a dramatic effect on this large holding. Every few years since , Eisner has received a megagrant of several million shares. Since the idea behind options is to gain leverage and since megagrants offer the most leverage, you might conclude that all companies should abandon multi-year plans and just give high-octane megagrants.

When viewed in those terms, megagrants have a big problem.

Look at what happened to John in our third scenario. After two years, his megagrant was so far under water that he had little hope of making much money on it, and it thus provided little incentive for boosting the stock value. And he was not receiving any new at-the-money options to make up for the worthless ones—as he would have if he were in a multiyear plan. It would provide him with a strong motivation to quit, join a new company, and get some new at-the-money options. Ironically, the companies that most often use megagrants—high-tech start-ups—are precisely those most likely to endure such a worst-case scenario.

Their stock prices are highly volatile, so extreme shifts in the value of their options are commonplace.

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