Lesson 3: Leverage

What does leverage have to do with stock options? Leverage is one of the most important, yet least understood, aspects of options. Consider the following:

• Understanding leverage is the key to understanding how your options create wealth.
• Leverage is the reason why stock options are considered one of the riskiest investments around.
• If you have more than one grant, leverage is the key to knowing which options you should exercise first.

What is leverage?

Leverage is used to amplify investment gains and losses on money invested. Financial leverage is created by using other people's money to increase the earning power of your own.

In personal finance, leverage is most commonly encountered in the economics of buying a home. Here's a simple example:

Let's say you want to buy a house for $100,000. Typically you would pay for that house by putting 20% ($20,000) down in cash and borrowing the balance from the bank. The $20,000 is your starting "equity," the net value of what you own. In other words, the difference between the value of the house and what you owe someone else is your equity. The bank loan (what you owe someone else) is what creates the leverage. It is called leverage because you are using someone else's money to make your money more productive - it "leverages" your investment. When leverage is created by borrowing money from someone else, there is a cost for the leverage. In a home purchase that cost is the interest you pay on the loan.

Because of leverage, in this example, if the value of the house goes up by 10% in the next year, your equity goes up by 50%!

Because the amount of the bank loan doesn't change, a $10,000 or 10% increase ($100,000 to $110,000) in the value of the home results in a $10,000 or 50% increase ($20,000 to $30,000) in your equity in the home!

Stock Option Leverage

The same dynamic works with stock options. A stock option is simply the right to purchase stock at a fixed price - the exercise price. The difference between the market price of your company's stock and the exercise price of your options is your equity. With options, what you owe someone else, in this case your employer, is what you have to pay to exercise your options, the exercise price. This right to purchase the stock at a fixed price is what creates the leverage. The wonderful thing about options is that, unlike a bank loan, you do not have to pay your employer anything to maintain this right! This is why employee stock options are sometimes considered to be like an interest-free loan from your employer.

Here's a simple example: Let's say your company gave you 50,000 options at $8 per share. If the current market price of the company's stock is $10, the total market value of the stock is $500,000 (50,000 x $10) and your exercise cost would be $400,000 (50,000 x $8). The difference between the market value and your exercise cost is your equity. In this case, your equity is $100,000 . Now if the market price of the stock goes up 10% to $11 a share, the total market value of the stock rises to $550,000, but your exercise cost remains the same ($400,000) and your equity rises from $100,000 to $150,000, a 50% increase!

This is why options are such powerful wealth creators. The leverage inherent in options magnifies the movements in the value of your company's stock. Relatively minor movements in stock price can result in a huge change in your personal wealth!

Magnifying the Risk of Loss

One of the most important things to understand about leverage is that it works in both directions; in the same way that leverage amplifies investment gains, it also amplifies losses. Continuing our example, if the price of the stock goes down 10%, from $10 to $9 per share, your equity would go down five times as much (50%), from $100,000 to $50,000.

Which to Hold - Which to Sell

The amount of leverage your options have is a key factor in determining which to hold and which to sell. As a general rule, if you want to preserve as much of the upside potential of your options as possible, keep the options with the most leverage. If the price of your company stock moves upwards, the options with the most leverage will experience the greatest percentage increase in value - these are the options which will do the most to increase your personal wealth.

Again, as a general rule, if you need to cash-in some of your options and you want to maximize the potential future value of the remaining options, you should cash in the options with the lowest leverage (lowest exercise price) first. However, if you are dealing with Incentive Stock Options (ISOs), you must also factor in the potential tax savings you may be giving up.

How do you calculate leverage?

Simply divide the exercise price by the current market price:

Leverage = Exercise Price / Market Price

So if the exercise price of your options is $8 and the market price of the stock is $10, your option leverage is 80% (8/10 = 80%).
 

Free Leverage Analysis Offer
for Corporate Executives

Deciding when to exercise and when to sell your options is a vexing but important question. While the decision needs to be made within the context of your total portfolio, taking into account your goals and your need for diversification, the amount of leverage in each grant is an extremely useful factor to consider. Often people do not realize the primary advantage of stock options is their leverage. Leverage accelerates the gains and the losses. Leverage has the advantage of buying a stock on margin without the risks. However, too often employees do not move in time to protect the equity earned when the stock is “in the money”.

How to use leverage to maximize the benefits of stock options
As an incentive to meet with you, we are offering a free Leverage Analysis for for the next thirty days. If you would like this analysis done for you without any strings or cost, please click on the link below, fill in the appropriate data and send it to us. We will then schedule a meeting with you to review the results of your analysis. If you live in the Southern California area we will meet personally with you. All information you provide is confidential. On request we will be happy to send you our Privacy Policy Statement.

Click Here to start your personalized Leverage Analysis

(return to top)   (on to Lesson 4!)