A New Approach to Maximizing Stock Option Awards
By Aaron Petersen
Wealth Research Specialist
Corporate executives at all levels frequently receive a significant portion of their compensation in equity, often in the form of stock options. The prevalence and complexity of these company-issued instruments make it important to have a well-conceived game plan in place for handling them. From our extensive experience working with executives, we understand the range of personal and professional considerations that are inherent in the options-planning process. As a result of new research we’ve conducted, we have developed an advanced approach to help maximize the value of options within the context of a broad investment portfolio.
Options, which typically vest over four years and expire a decade from the grant date, are one of the more common forms of equity-related pay. Two other types, restricted stock and restricted stock units, have grown in popularity, partly because options have come under increased shareholder scrutiny and tighter financial regulation. Still, options remain a central element of equity-related packages, and many executives continue to hold grants issued in the past.
The basic decisions facing options holders are when to exercise and whether to cash out or hold the underlying stock when they do. Conventional decision-making centers on such factors as the intrinsic value of an option or the tax consequences of exercising. People also tend to base their choices on mental shortcuts. For example, executives wanting to diversify their portfolios typically cash out at vesting, whereas those seeking to delay taxes often wait until shortly before expiration.
The problem with following such broad rules of thumb is that they can lead options holders to either cash out too quickly or hold on too long, thus running the risk of leaving money on the table or letting their options expire worthless. According to a recent article in the Wall Street Journal, that’s exactly what happened to some executives at Bank of America, as options issued before the 2008 financial crisis expired worthless because the shares now trade well below their pre-downturn peak.
Although diversification and taxes are important considerations, our research reveals another factor that’s just as essential — the relationship between a stock’s dividend yield and its expected volatility. We examined companies in the S&P 500 over a 10-year period and placed stocks into one of four categories, or quadrants: those with high dividends and low volatility; low or no dividends and high volatility; high dividends and high volatility; and low or no dividends and low volatility. Traditional options models tend to overlook dividends entirely. But our research shows that each of these quadrants has unique characteristics that can signal when and how to proceed based on an executive’s personal objectives. Below are some rules of thumb for each set of characteristics.
High Dividends/Low Volatility
Executives of companies in this quadrant who are looking to build a position in the underlying stock can potentially benefit by converting options well before expiration and holding the actual shares in order to collect the dividends. The reason is simple: unlike stockholders, individuals with options don’t receive any of the dividends that are paid out on the underlying shares. For options holders at companies with generous payouts, that can mean forgoing sizable amounts over time.
Another reason for exercising well before expiration is that low-volatility stocks are, on average, relatively unlikely to plummet or surge in price. Thus, the upside of continuing to hold the option can be modest compared with the potential benefit of collecting dividends over time.
Executives who plan to cash out can also benefit from exercising early. By their nature, options become increasingly risky over time. That dynamic occurs earlier in this quadrant than in the other three. Those who exercise early avoid the risk of holding too long.
Low or No Dividends/High Volatility
Many companies in this quadrant either don’t offer a dividend or have such a low payout that it doesn’t meaningfully affect the value of the option. Therefore, it’s generally advisable for executives to hold their options for a greater number of years to gain from potential price appreciation in the stock.
However, there is a risk of holding for too long. As the expiration date nears, the value of the option becomes increasingly synchronized with the underlying stock. In some cases, the option value can swing even more dramatically than the stock price. That’s especially so in this quadrant, where stocks have high volatility but little or no dividend to cushion against an unexpected drop in share price.
For that reason, it may be advisable to hold an option no longer than two years or so before expiration. Depending on the outlook for the company and the executive’s personal goals, it may make sense to cash out at that point given the limited time that the stock would have to recover from a sell-off.
High Dividends/High Volatility
For this quadrant, it’s necessary to weigh the potential benefit of collecting dividends against the heightened risk of a big drop in the share price. In general, it’s advisable to hold for a longer period of time. That’s because high volatility tends to have a larger impact on the value of an option than do dividends.
However, decisions in this quadrant are highly dependent on circumstances, especially the outlook for the company and the personal goals of the options holder. There are times when it’s preferable to exercise early and times when it’s better to wait until the option is closer to expiration. Executives who choose to hold on to their options should reassess their situation no later than two years prior to expiration. It may be advisable to cash out at that point given the limited time for a stock to recoup a sizable loss.
Low or No Dividends/Low Volatility
As with the high-dividend/high-volatility quadrant, there is a bit of a juggling act when volatility and dividends are both low. Depending on the specific stock and the executive’s financial circumstances, early exercise is advisable in some cases, but delaying until near-expiration is preferable in others.
In contrast to the first three quadrants, however, it’s typically best to exercise these stocks near the middle of their term. That’s because the low volatility in this quadrant reduces the chance of a big price spike in the second half of an option’s life span. In other words, there can be less benefit from holding an option until expiration.
Regardless of the quadrant a stock falls into, options-related decisions are always complex and involve a variety of factors. Options strategies must be made within the context of an overall investment portfolio and tailored to each executive’s financial circumstances and personal goals. We understand that executives often face certain constraints and conflicting objectives when making these decisions. Contact your Investment Counselor to arrange for a personal assessment of which strategy may be best for you.
Aaron Petersen is a wealth research specialist with particular expertise in investment planning, equity compensation, retirement and charitable entities. He has been with Capital Group since 2000.