Leverage is a key concept in investing, and one that has special application to stock options. If you’ve received options as part of your compensation, you’ll want to understand how leverage affects your profit.
The concept of leverage is more familiar in the context of real estate investing. Suppose you own investment property worth $1,000,000. You owe $800,000 on the mortgage, so your equity in the property is $200,000. This smaller equity figure is the actual amount you have invested, but the property is worth five times as much.
Now consider what happens if the value of the property increases by 10%. Its value would go up to $1,100,000, but your mortgage would still be $800,000 and that means your equity would soar to $300,000, a 50% increase. The real estate is worth five times as much as your equity, so boost in your equity is five times as great (percentagewise) as the growth in the property value. Bear in mind that this works in both directions, as many investors have lately learned to their woe: in this example, a 10% decline in value will destroy half your equity.
You didn’t borrow to buy your stock options, but the same concept applies. Suppose you hold options to buy stock currently valued at $100,000, and your exercise price is $80,000. You can exercise the option and sell the stock for profit of $20,000, so we might say that’s your current equity in the option, although different terminology is usually applied to stock options. (Built-in profit may be called the spread, or more formally, the intrinsic value.) The stock is worth five times as much, so any change in the stock price will affect your equity by that multiple. A 10% change in the stock price — in either direction — alters your equity in the option by 50%.
Option leverage is both good and bad, supercharging your profits but also exaggerating losses. In managing your stock options you need to think of them as part of your investment portfolio, and this leverage contributes to the riskiness of that portfolio. It may make sense to temper your overall risk with a relatively conservative approach to the rest of your investments.
Option leverage is the ratio of the stock value to your built-in profit, so it becomes smaller as the stock price increases. If the stock price went up so sharply that your option allowed you to buy $100,000 worth of stock for just $50,000, the leverage factor is just 2 to 1. Sometimes I encounter people whose options have almost no leverage at all, perhaps because they were early employees of a company that later had a successful IPO. If your option allows you to buy shares at 15 cents and the stock is worth $30, you can forget about leverage. For practical purposes, your risk is the same as if you owned shares.
In addition to the built-in profit, stock options have another element of value known as time value. Because of the name, many people assume this portion of an option’s value correlates closely with the amount of time left until the option expires. The remaining term of the option is important factor of course (an option that’s about to expire has no time value) but time value is also a function of leverage. If the stock price soars to a level where your option has little leverage, the option also has little time value, even if it has years to run until it will expire. Diminished time value can be an important factor in deciding when to cash in your option profit — but that’s a topic for another day.
Two of our books deal with how to manage stock options. Consider Your Options is for general readers, and Equity Compensation Strategies is for professionals who offer advice to option holders.
