Lynn Chen-ZhangEncouraging executives to diversify their employee stock options isn’t easy, but it’s critical for reducing risk. The following case illustrates an effective approach to this challenge.

The client is a 50-year-old executive at a medical-devices company. He planned on using his company stock options valued at $3.5 million to support him and his wife in retirement, and to help pay for their children's college educations.

His advisor, Lynn Chen-Zhang, wanted him to begin exercising his options, selling the underlying stock and diversifying the proceeds, but the man wasn't eager to make any moves. Diversification didn't seem important to him, and he was tempted to wait until the options' were about to expire before exercising them.

So Ms. Chen-Zhang illustrated the importance of diversifying stock options using the StockOpter leverage table. In 1999 she watched a client lose close to $5 million in employee stock option value when his technology company collapsed so she now shows clients what happens to the value of their options if the company stock price falls significantly.

"When you just talk about diversifying, executives will nod their head like they understand, but once you're done they'll stop thinking about it," says Ms. Chen-Zhang, a partner at Zhang Financial, which manages $2 billion for 1,000 clients in Portage, Mich. "That's why it's important to find a way to make them visualize the risk."

In this case and using the following analytics from StockOpter.com, she asked her client to imagine what would happen if his company stock declined 20% from its current price of approximately $96. This was a realistic possibility, because a year before the shares had traded for $77.

Lev Chart for Lynn

She then reminded the client that stock options have a fixed exercise price which means a falling stock price has greater impact on the value of those options than it does on individual shares of the stock. For example, if the company's stock price fell by 20%, the value of the client's options would fall by 47%, to $1.8 million.

Ms. Chen-Zhang continued the discussion by showing her client what would happen if the shares fell another 20% to $61, the stock price in 2013. In that scenario, his options would be worth $700,000, an additional 61% decrease in value.

To drive the point home, the adviser showed the effects of another 20% drop to $49, the stock's 2011 price. If this happened, and historical share prices showed that this could be a real possibility, the client's options would be worth less than $150,000.

The adviser closed her argument by explaining that the leverage effect inherent in stock options, due to the fixed exercise price, makes them more volatile than holding the stock itself. "With stocks you can just hold on to it until it goes back up," she says. "But options expire so the leverage effect has to be factored into the decision."

The client saw how easily he could lose the wealth he was counting on to fund his retirement and children's educations. He agreed to allow Ms. Chen-Zhang to begin exercising the options, selling the shares, and reinvesting the proceeds in a diverse mix of stocks and bonds.

Ms. Chen-Zhang notes that it can make sense for an executive to retain options when a company's stock appears to be undervalued and there are several years left before those grants expire. However, if the expiration date is nearing, she recommends that her clients exercise and diversify at least a portion of the options to reduce risk. And because many executives have much of their wealth tied up in options, it's critical to show them the numbers.

"I use StockOpter's leverage table because I needed a way to help executives see the very real need for diversification" Ms. Chen-Zhang says.

2 Comments

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  1. Steven Wadle says:

    Great article

  2. John says:

    It is apparent, from the graphs, that the percentage changes of the options approaches the percentage change in the stock, the father that the stock goes above the exercise price. And I assume that the graphs show the movements of the stock over a very short period.

    If the calculations were made over a reasonable period, the drops in the ESOs would be greater and the increases would be less as the “time value” will have eroded somewhat. So when the erosion of the “time value” (i.e. the theta) is considered, and since the erosion of the “time value” is greatest when the stock is trading near the exercise price, the possible loss in the options value is much greater when the stock is trading nearer to exercise price than if it were trading far higher than the exercise price.

    What this means is that the risk of holding the ESOs is much greater, when the stock is 30% or 40% above the exercise price than if the stock is trading 80% or 95% above the exercise price.

    Therefore if an ESO holder wants to reduce risk when the risk is highest, making early exercises, selling the stock and diversifying is a worthless strategy. In fact any Fiduciary who advises such a strategy runs the risk of a law suit for violation of his/her duty to the client.

    Generally hedging against company stock by selling calls or buying puts is far more efficient than early exercises, especially when the risk is greater. The ESO holder could hedge by hedging against correlated stocks if the company prohibits hedging against company stock.

    Hedging reduces risk while extending the alignment between the ESO holders and the shareholders. Early exercises, selling and diversifying the net proceeds eliminates the alignment. And given the penalties of early exercises in the form of forfeiture of the time value and the payment of early compensation taxes and the questionable merits of diversifying, if you want to reduce risk you must hedge.

    Almost every top executive of major companies hold their ESOs to near expiration and never make early exercises sell and diversify. Why?

    John Olagues

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