The Advisors' Blog

– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP

With all the gyrations in the market lately, I couldn’t help but wonder what this might mean for stock options. Yes, stock options have already experienced a bit of a decline in popularity in recent years thanks to FAS 123(R), but will the flight from options increase? (To read a better version of this blog, see this document with four charts added.)

Not being able to let this go, I ran some quick calculations of volatility for the Dow 30 stocks. The results confirmed that volatility had increased dramatically in 2008 (through October 17th) compared to 2007, 38.99% vs. 21.80% (based on a daily volatility calculation using adjusted closing stock prices), an increase of approximately 80%.

To see how this dramatic increase in volatility might impact stock options, I then looked at volatility for the same group of companies over two three-year periods (i) 1/1/2006 to 10/17/2008, and (ii) 1/1/2006 to 12/31/2007. Not surprisingly, the rise in volatility that showed in the year-over-year comparison also echoed in the three-year volatilities, 24.11% vs. 19.84%, an increase of approximately 22%.

So, how might this impact the future use of stock options? Options are going to become more expensive to use and, if the market is in a prolonged bear market (such as that between 1966 and 1982), there may not even be much upside potential. Additionally, the new bailout-related mandates, including admonitions against incentives that encourage “excessive risk,” are also likely to have an adverse impact on the use of stock options.

However, the stock prices themselves will be depressed compared to prior periods, so wouldn’t the impact of increased volatility be offset by the decrease in the stock price? To test that I took the closing median stock price of the Dow 30 companies for each of the 3 year periods, $33.33 for 1/1/2006 to 10/17/2008 and $46.99 for 1/1/2005 to 12/31/2007, and then used the medians of the most recent FAS 123(R) assumptions disclosed by the Dow 30: risk free interest rate of 4.80%, dividend yield of 2.33% and an expected life of 6.0 years, and ran a Black-Scholes model of a “median” stock option for the Dow 30 in each three-year period.

The results confirm that the relative cost of a stock option will increase as a result of the increase in volatility for 2008. The Black-Scholes values were $8.45 (25.36% of face value/median stock price) for the 1/1/2006 to 10/17/2008 period and $10.45 (22.23% of face value/median stock price) for the 2005-2007 period, representing a 14% increase in the percent of face value/median stock price. So, even though the stock price has dropped as has the Black-Scholes value, the FAS 123(R) cost for stock options will represent a larger percent of the stock price.

Is this the death of stock options? Probably not. But, their increased cost, possible limited upside and the new mandate to avoid excessive risk in compensation programs (at least for those companies participating in the financial bailout) will cause a good number of companies to reconsider their use of stock options, and, most likely, many of them will veer further away from stock options and towards full value awards like restricted stock units and performance shares/units. In these challenging times it will be harder to justify leveraged incentives that can result in greater upside potential than is the case for shareholders whose equity participation has come the old fashioned way – by buying full value shares.