GE Stock Options: Game of Chance or Mathematical Exercise?

With the recent performance of GE’s stock price, now may be an opportune time to review where your stock options stand.  

You can view stock options in one of two ways—as somewhat of a game of chance (where you roll the dice and hope for the best) or as a mathematical exercise designed to put discipline and strategy behind your decisions.  While it’s easier to close your eyes and hope for the best, at Clarity Wealth Management we believe that a scientific risk-managed approach makes more sense and offers more upside over time than the easier, less analytical approach to a stock option strategy.

Having dealt with stock options for almost three decades, the number one question we get from nearly every corporate executive is when to exercise their stock options.  Because of that, we’ve developed a better way of guiding our clients with regards to knowing when to “hold 'em” and knowing when to “fold ‘em”.

WHERE TO START WITH STOCK OPTION PLANNING?

In general, there are three important questions we walk through with our clients –

What are my options worth?

There are two factors that determine an option’s true value – “in-the-money” value and “time value.”  Let’s go over each – 

1. “In-the-money” value.  This is the dollar value of an option if the current stock price is greater than the exercise price of the stock option.  Let’s use the 2017 grant with an exercise price of $90.10 as an example.  If GE’s current stock price is $181.44, then the in-the-money stock price is $181.44 - $90.10, or $91.34 per share.  With 1,000 options, your in-the-money value is $91,340.  
2. “Time value.” This is a way to measure how much potential value is left until the option expires in addition to the in-the-money value. In general, the more time until expiration and/or the greater the volatility (fluctuation) of the stock price, the greater the remaining time value. Why would more volatility increase the time value? Because volatility is on both the downside AND upside (more on the downside part later). More time means more opportunity to have that upside potential work in your favor.

This can be helpful to understand because as the time value decreases (and therefore remaining potential upside), the value of holding that stock option also decreases while the risk of holding that option increases.

We measure both to determine an option’s “full value.”  An option’s full value is the in-the-money value plus the remaining time value.  To put some numbers to this, here are the different full option values for a few of the GE stock options – 

When should I exercise them? 

Because of that question’s importance and implications on your financial life, we use a disciplined and mathematical approach to option exercise planning called the Clarity Ratio®.  To find out your ratios, we need to look at both the time value and the full value.  Simply put, the ratio is the time value divided by the full value.  Using the 2017 grant, that would be $11,481/$102,821, or 11.17%.  The lower this ratio, the more compelling it is to exercise the grant.  

How should you use this ratio to make a decision though?   To keep it simple, a ratio of 11% means that 89% (100% - 11%) of the option’s full value has been realized.   As time moves closer to expiration, this ratio will go lower, as will it with an increase in stock price.  The overriding question is, “is it worth continuing to hold this option to potentially get the remaining 11% of its value?”  That depends, and we will talk about that in a bit.  

This ratio is the starting point to decide which options you should consider exercising or not.  

What else should I consider to make a decision? 

There are some basic financial planning questions to incorporate into the decision – 

1. Income tax considerations – is there a large difference in your tax rate this year vs. next? Are you close to a new marginal bracket or a tax threshold?  
2. Diversification - should you consider other investment opportunities by having cash to reinvest in a diversified portfolio? 
3. Personal goals - is there a specific financial goal or expense you must fund this year?  

If there is a specific goal you need to fund or you need to diversify away from company concentration, then you might use a higher ratio as your decision point.  

In addition, let’s go back to the Clarity Ratio® and talk about upside vs. downside risk.  We have seen more than once the human emotion of greed come into play.  Let’s say we have an option grant with a Clarity Ratio® of 5%.  In other words, 95% of that option’s value has been realized.  The stock price is doing well, and you set a price target $5/share above the current price knowing that the option is nearly at full value.   But then the stock price turns south and the new price target isn’t reached.  

This example that we’ve seen happen is why it’s important to understand the upside AND downside potential inherit in stock options.  Big picture, an option’s value changes MORE than the change in stock price…here’s an example below – 

Looking at the 2017 grant with the highlights, a 10% drop in stock price results in nearly a 20% drop in option value!  The value drops from $91,340 to $73,200.  

So, maybe it isn’t worth trying to squeeze out another dollar or two on the share price.

In summary, here are the critical things to keep in mind when reviewing your stock options – 

1. The option’s full value, not just its in-the-money value.
2. The option’s Clarity Ratio®.  Is it worth continuing to hold if an option has already realized 90% of its value, for example?  
3. Your personal circumstances to guide your decision.  In other words, what is the true purpose of this money?  What will these options help you and your family do from a financial perspective?  Of course, things like tax brackets and diversification needs are important, but at the end of the day, there are people with goals behind the money, and accomplishing those is what’s most important.   

Please feel free to reach out with any questions at matt@claritywealth.org.  

_{This is a hypothetical example and is for illustrative purposes only.  Actual results will vary. Past performance does not guarantee future results.}