<I>TSC</I> Options Forum: Underwater Doesn't Mean Worthless - TheStreet

<I>TSC</I> Options Forum: Underwater Doesn't Mean Worthless

Many readers wanted to know more after Microsoft's big decision on employee options.
Publish date:

Steve -- I would like to get your thoughts on Microsoft's (MSFT) - Get Report decision earlier this week to do away with stock-option grants for employees. A few things aren't clear to me. How will J.P. Morgan (JPM) - Get Report value the options it's buying, and how will Microsoft employees know if they're getting a good deal? Or is any money good, considering that many of the options are worthless? -- Thanks, Brad

News of Microsoft's planned termination of employee stock options, and the proposal to allow J.P. Morgan to purchase all previously granted options that are still outstanding, provoked a number of reader questions about what it all means.

While many details of Microsoft's plan haven't been finalized, and I can't really speak about what it means in terms of trends in corporate policy toward employee options, this does provide a great venue for discussion on many important concepts about options.

First, let's address the valuation question. Just because an option is out of the money, meaning it has no intrinsic value, it's not necessarily worthless. Other components, such as time and volatility, are equally important in determining an option's theoretical price.

I don't know if J.P. Morgan will be using the

Black-Scholes model in valuing the options, but I can guarantee the options will be assigned a value greater than zero -- whether it will be a "fair value" is another discussion.

An employee can easily use an option-pricing calculator, such as the one available on the Chicago Board Options Exchange

Web site, to get a good idea of a stock option's value by simply plugging in the known variables.

Stock Options vs. Options on Stocks

But this is where we need to draw the distinction between options granted to employees and those that are publicly traded on an exchange. Unlike exchange-traded options, which are fungible, employee stock options have limitations on transference to a third party, time restrictions in the form of vesting periods, forfeiture if one's employment is terminated, and no standardized contract specification.

So while it's quite easy to calculate a theoretical value for a specific option at any given point in time, the fact that an employee is unable to sell that option does make it, for practical purposes, currently worthless. Even a $100 bill in your pocket is of little value if you're restricted from spending it.

By being allowed to sell their stock options to J.P. Morgan, Microsoft employees are getting an opportunity to monetize their options at their current value. The attraction for J.P. Morgan is that the firm will most likely be paying something slightly below "fair value," providing the potential to lock in a profit through hedging transactions.

Though the arrangement will probably be quite complicated, the essence of the hedging will take form in two ways: selling other existing exchange-traded Microsoft call options and selling short the underlying Microsoft stock.

The effect of the former will be a compression of the implied volatility in Microsoft options, especially those with long expiration dates. This price reduction is simply the result of an increase in supply (sellers) relative to demand (buyers).

Because of Microsoft's size, with a market capitalization of around $290 billion and nearly 11 billion shares outstanding, the impact of shorting stock should be minimal. But if a smaller company were to adopt this plan, its share price could be hurt. Essentially, it accelerates the selling of option-related shares, referred to as a stock's overhang, into a relatively short period of time. Under normal circumstances the overhang is sold off at various intervals and price levels.

Monetization Options

I have no idea if Microsoft's proposal is the beginning of a trend, but I'm sure employees at other companies wish they could monetize their underwater options. And I'm here to tell you there is a way, right now, even without your company adopting the program. Basically, all you need to do is take a page out of J.P. Morgan's book and hedge the employee stock-option position by using exchange-traded stock options.

Of course, bear in mind that company employees, especially those at the executive level, should be aware of all applicable insider-trading restrictions, including blackout periods, etc. Also, make sure to check with your corporate counsel prior to engaging in transactions of this sort.

Let's use


(CSCO) - Get Report

as an example. The company has a large float, big capitalization, actively traded exchange options and plenty of underwater employee stock options.

Assume an employee has 10,000 stock options with a $40 strike price that vest in two years. With Cisco currently trading at $18.50, if I use my handy options calculator I see that the options have a theoretical value of 55 cents. By selling some exchange-traded Cisco call options and collecting the premium, one can monetize a portion of the employee stock options.

This past Friday, the January 2005 call with a $40 strike price traded at 20 cents. This is a deep discount to our theoretical value. Some of the discrepancy is a result of the option expiring six months sooner than our example vesting period, and some is simply the result of supply/demand factors -- but it's better than nothing.

In selling these long-term equity anticipation securities, or LEAPS, an investor is basically creating a calendar spread. Depending on your trading savvy and risk threshold, you could sell calls with a lower strike (higher price) and shorter duration in an attempt to collect more premium. If those expire worthless, roll the position into the next time period.

Considering Ratios

There are two

very important

points to be aware of. Unlike exchange-traded options in which each contract represents 100 shares of the underlying stock, most employee stock options are issued on a 1-to-1 basis, meaning one option represents one share. In our example above, to "sell out" the entire 10,000 stock options, the employee would only need to sell 100 of the January 2005 calls.

Also, since employee stock options aren't fungible or transferable, they most likely can't be used to offset the margin required to sell 100 call options short. The amount of money one needs to deposit into a trading account to establish such a position can be substantial.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.