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Employee Stock Options
Employee Stock Options, normally abbreviated as ESOs, are options granted to an employee by a company giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time. They usually have some significant differences from normal call options. They cannot be sold, expire in many years, often up to 10 years, and have a vested period before the employee can take advantage of them, typically 3 to 7 years. If the employee leaves before the vesting period is over, the stock options are lost. During the technology boom of the late 1990’s, ESOs were used extensively to attract employees to start-up companies.
During the 2000-2002 bear market, ESOs were the subject of much controversy. There is still some fall-out and publicity as companies and the SEC continue to wrangle over how and even if they should be used. For many years, companies could give ESOs to their employees and not have to pay anything. They did not reduce the company’s earnings. However, ESOs must now be expensed according to the Financial Accounting Standards Board. Unfortunately, how do you come up with a price for something that is currently worthless?
To make matters worse, while some people became fabulously wealthy through ESOs during the Internet mania such as John Moores, a previous owner of the San Diego Padres and Peregrine Software, many other people were soaked with crippling tax burdens on worthless pieces of paper when their companies collapsed! How can that be, you ask? The Alternative Minimum Tax, AMT, does not care if you sell the stock of exercised options, only that you exercised them. You still owe the tax on the paper gain, even if you never were able to realize the gain because the stock price collapsed after the options were exercised. Bizarre!
“Wait a minute. Did you ask, ‘How do you come up with a price for something that is currently worthless?’” Yes, that is correct. Since many ESOs are “out-of-the-money”, often by a large amount, or cannot be exercised for a long time, or both, how does the company put a price on it? The financial world currently uses a system called the Black-Scholes Option Pricing Model. It may sound impressive, but it is really very silly, in the humble opinion of Your Humble Author.
Side note: Myron Scholes won the Nobel prize for Economics for this model and then proceeded to partner with John Meriweather, the famed bond trader that we discussed in chapter 1, to create Long-Term Capital Management. In 1998, they almost brought down the global financial system. The story is recounted in the book, When Genius Failed, by Roger Lowenstein, and the PBS NOVA documentary, The Trillion Dollar Bet.
For example, for a stock currently selling for $7.50 per share and ESOs with an exercise price of $10 and options that cannot be exercised for 3 years, the Black-Scholes model might say that the employee stock option is worth $2.50. What? You cannot sell the options. You cannot exercise the options for 3 years. The options are “out-of-the-money.” How are they worth $2.50? The stock price might never go over $10. What if the stock price does breach $10 and you exercise the options and then you see the stock price plummet? If you are unfortunate enough to be affected by the AMT, you might have to pay taxes on the paper gain that you never were able to realize!
Stock Index Options
A stock index option is a put or call option written on a specific stock market index, such as the S&P 500. Stock index options allow an investor to purchase or sell options that respond to a stock market index. For example, an investor can hedge a portfolio by purchasing a put on a stock index option that represents the portfolio. If the market goes down and takes the value of the portfolio down with it, the stock index put option will act as insurance against the large loss because it will rise counter to the market. Of course, it will only do this until it expires. And then you have to buy another stock index put option. Let’s keep in mind that insurance is not free. There are dozens of indices represented including large-cap, mid-cap, and small-cap stocks, domestic, international, regional, country-specific markets. The possibilities are endless … and so are the fees. Whether speculating or hedging, it is still risky or expensive or both.
Other Types of Options
A few other types of options include interest rate options, currency options, and LEAPS. Interest rate options are put and call options written on fixed-income securities such as bonds. Interest rate options can be used as insurance to protect a bond portfolio from adverse interest rate movements, similar to the stock index options above for stocks. If interest rates rise, the value of the bond portfolio will fall. To protect against this, the investor can purchase insurance in the form of an interest rate option that would rise if interest rates rose. Again, the option eventually expires and the investor would be required to purchase another option to continue any protection.
Currency options are put and call options written on foreign currencies. These can be an important tool for foreign investors and multinational corporations who must periodically convert United States Dollars to and from other currencies. Unless we as retail investors regularly have significant amounts of our U.S. dollars converted to and from other currencies to buy and sell foreign securities or other assets, they would not be a useful tool for us.
Last, LEAPS is the acronym for Long-term Equity Anticipation Securities. LEAPS are long-lived options that expire in 9 months to 3 years. These instruments were introduced by the Chicago Board Options Exchange (CBOE) in 1990. Because of the increased time value, LEAPS command a higher option price, also known as the option premium, than shorter term options.
A warrant is a long-lived option that gives the holder the right to buy stock in a company at a price specified on the warrant. Warrants are often issued as an incentive to investors. They may be issued by the same company that issued new shares of stock to the public. They sometimes accompany newly issued bonds or are given to employees as compensation, similar to ESOs. Unlike options, where each contract represents 100 shares of stock, one warrant represents the right to buy one share of stock. Warrants are usually always call options, however, there are some put warrants.
Final Comments on Options
STAY AWAY FROM THEM!
The possibilities are endless, and so are the losses and commissions. Options are a zero-sum gamble. Someone wins, someone loses. Of course, the brokerages and exchanges make money no matter what happens. But don’t take my word for it! Take a look at what the folks who want to teach you how to trade options have to say about options!
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Here is one last attempt to steer you far away from options. Check out this unfortunate soul who committed suicide when he thought he had racked up $700,000 in debt selling options. He was wrong. He did not actually incur the debt. He was just reading his account status incorrectly.