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Writing Option to Improve Option Value

Contributed by mm | January 6, 2010 8:56 PM PST

clip-stockoption.jpgYesterday I shared that I'm working on the financial problem to maximize return on my soon-to-expire employee stock options. An outright sale is an easy path to choose, but does it make the most economic sense?

One thing to note about stock option: it does not only bear value when the strike price is lower than the market price (in the case of "call" options, which is the case for all employee stock options), it bears time value too. For example, for stock option of the same strike price, the further the expiration date, the more value the option is.

So, if one determine the market price is right but the employee stock option grant still has some shelf life, one can sell the stock option (instead of exercise the stock option) in the open market. Technically, it means to write (or "sell to open") a call stock option position with strike price and expiration date similar to one's employee stock option grant.

To illustrate this in an example, let's use the same data set in my last post:

Stock Option Strike Price: $26.4375
Quantity: 2,222
Expiration Date: February 12, 2011
Price of Underlying Stock: about $31

As we calculated in the last post, the gross proceeds before tax will be ($31 - $26.4375) x 2,222 = $10,138.

One can look at the option table and find the January 2011 $27.5 Call LEAP option is trading hands at $5.20. (Standardized options are trading at specific intervals, so we take $27.5 as a strike price proxy.)

To implement the strategy, one can write 22 contracts of such option. This transaction means one will receive 2,200 x $5.20 = $11,440 upfront for selling the right to someone else to buy 2,200 shares of the underlying stock at $27.50 from the seller before January 2011.

So what's the difference? Below is the table that shows how this strategy will work.

6391-option.jpg

Let's take the $31 row for a quick walkthrough. One year from now, if the price of the underlying stock is still $31 (as today), our hypothetical investor will receive $10,138 by exercising the employee stock option (column [A]). Also, when he sells the stock option in January 2010 in the open market, he will receive $11,440 upfront (column [B]). Finally, if market price in January 2011 is $31, someone else will choose to buy the underlying stock at $27.50 from him, which will require him to pay out 2,200 x ($31 - $27.5) = $7,700 (column [C]). The sum of all three: $13,878 (column [D]), which is a good 35% improvement over the original $10,138 he will otherwise get if he chooses to exercise the employee stock option upfront.

Actually, by taking the additional hassle to write the call option in the open market, our hypothetical investor will be able to lock the income of at least $11,440 in the worst case even the stock price plummets tomorrow. And he has a fairly good shot at getting $13,800 or more if the stock doesn't fall too much. In other words, he is guaranteed to do (much) better than cashing out the stock option upfront.

One thing to consider is the tax implications. Let's explore this in the next post.

This Post Has Received 52 Comments. Share Your Opinions Too.


john galt Commented on January 7, 2010

Ha! I guess I should have read this post before responding to the previous one. Anyway, one other thing you might consider before executing this strategy is that the current volatility is quite low. Volatility is also a key in determining an option price. So, if you think there is a chance that the markets (or your stock in particular) will see more volatility in the near future, you may be able to get paid more for writing options by waiting. Of course, you'll be losing some time value and who knows what the stock price will do. Just another variable to consider. Basically, when the volatility is low it's a good time to buy options, when it's high it's a good time to sell options.


Randy Commented on May 8, 2010

So let me get this straight. Your company does not give you real options that you could just sell on the open market themselves, correct? (Most don't, only a few do)

Instead you are writing a call at around the same price. I've thought about this as well, but I have always been told that this is essentially the same as shorting your company's stock- because when you right a call, you are basically better the price doesn't go up.

I'm not quite certain whether this is illegal or not, but at my company we are told that we cannot do anything of the sort- we cannot buy or sell options of our own shares (or sell them short) but you are free of course to buy shares on the open market.

I would be very surprised if your company does not hold a similar position with respect to options activity in their stock. Please advise. I would love to get away with this kind of thing, but I'm fairly certain I can't, and I really doubt you could either.


MM Commented on May 9, 2010

Randy, my employer maintains an "insider" list and people on this list can only exercise stock options or trade company's stock in a certain window every quarter, and has no other policies for other employees. I got off that list when I changed my job last year, so I have a free hand executing the strategy now.


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