If you’re the holder of company options, you’re in the box seat to decide when and if you will exercise your right to become a shareholder or increase your holding in that company.
Put simply, an option is a contract to buy a share. It's an equity instrument that gives an investor the right but not the obligation to buy (or sell) a share at a fixed price by a given date.
In this article:
- When are options commonly used?
- What are some of the rules governing options?
- How are stock options tied to stock prices?
- What should investors watch out for?
When are options commonly used?
An option can be used as a financial incentive, much like a discount offer. They can be an enticement to investors to participate in capital raising.
“At times there’s an acquisition, but the way you normally see them is alongside placements or a capital raising,” says Davide Bosio, WA state manager and director of Corporate Finance at financial services firm Shaw and Partners.
In the case of employees, executives and company directors they are a way to create ‘buy in’ or loyalty – a sense that their fortunes are quite literally joined to the fortunes of the company.
“They’re a mechanism to incentivise executive teams and CEOs – this is a way for companies to reward staff and create shareholder value over time,” says Bosio.
“The company might say, ‘If you’re working here in three years’ time and the share price has risen above a stipulated amount, you’re entitled to exercise this option’.”
"This can be very lucrative and it’s how a lot of company executives make the money they do. A lot of CEO pay may be equity-based through performance shares or options that they receive.”
“The thinking is, if the shares go up, your work is responsible, and you deserve that package.”
Of course, there are also exchange-traded options, which can be sold on the market to investors, just like other financial instruments.
What are some of the rules governing options?
The main characteristics of any option are its exercise price and expiry date. If an option is trading at 20 cents, that’s the exercise price – it's usually lower than the market price, because that’s the point of options. This means that if you want to convert that option into a share you need to pay 20 cents before the option’s expiry date.
If you pay that amount by that date, you convert it into an ordinary share. And if the shares are trading at anything more than 20 cents at the time you exercise the option, then you’re getting a discount.
Most companies will factor in what an option is worth at the time of issuing, using the Black and Scholes valuation methodology, which has since 1973 been the key mathematical formula for determining option pricing.
Options can be listed or unlisted – listed options can be traded on an exchange, while unlisted options are part of a private agreement. They can include the right to ‘call’ or buy shares, or to ‘put’ or sell shares.
“If an option is listed you can just sell the option on the market and it will trade at a premium at that valuation,” says Bosio. “An unlisted option means you need to exercise it. If it expires, you lose the opportunity to buy the shares at that option price. Once you exercise the option, the money goes into the company. It’s a right, but not obligation, to buy shares at a set price and time in the future.”
How are stock options tied to stock prices?
Options are derivatives – that is, any instrument linked to another asset, from which they ‘derive’ their value.
In share terms, the value of an option is that it is usually set at a price that is low relative to the market value of the share. The other value to the option holder is the length of time set on the option, which allows them to exercise the option to buy into a company for a good price, at a certain point in time.
“Typically there are two main things investors use to value an option – intrinsic value and time value – although there are a few other factors at play like volatility and interest rates,” says Bosio.
Intrinsic value is straightforward: “The intrinsic value refers to the price of the underlying share in comparison to the exercise price. If the share is trading at 40 cents and you get 20 cents, then you’re making a profit of 20 cents.”
But things become more interesting where there is time value built into the option. With a long lead time, you can take the option to strike and pay your 20 cents per share at any point in that time frame.
“With a five-year option, where shares could be worth a lot more in that time, there is significant time value, as compared to a situation where there are, say, only 10 days left of trading. As the time period specified in the contract decreases, that time value diminishes too,” says Bosio.
“A longer time period means the investor is in a highly leveraged position to see where the market is going and how the investment might take shape."
What should investors watch out for?
If a whole bunch of option holders are about to convert, they can sell for a cut price when the shares are much more valuable than when their options were issued.
“There are instances where, when options are deeply in the money, investors should be conscious of who owns the options and how many options may be converted, because that can create quite a large seller in the market as those options are exercised," says Bosio.
"They can be sold down quite aggressively and it can create a dip in company value.”
This is particularly true of IPOs offering a free listed option with every share. “We’ve seen many IPOs over the last 18 months in particular, and to raise money they might include an offer for a free listed option per share, which you can trade.”
“But what we do see at times is that shareholders might decide to keep the option as free exposure and sell the shares at the going rate. They then get that money back and end up with a free piece of paper – the option amount – and there's the profit. The option is used as a mechanism to reduce investor entry cost.”
“The problem is that these free listed options can result in short-term selling and weakness in the share price when IPOs come on.”
Options and derivatives are highly complex instruments and any investors looking to better understand them should do their research.
“The ASX publishes a lot of info about options, but you should look for a qualified advisor who specialises in options – there are specific accreditations for advisors who provide real advice around options and option strategies. It can be quite a confusing field for those encountering them for the first time.”