Based on leverage and the Insight Ratio®, you can probably wait a little longer before selling.
NFLX 7-1-22 to 2-7-23
No, I’m not predicting that NFLX will be going up even more. I have no idea what the stock is going to do in the short-run and neither does anyone else. It would be a fair guess that in the long-run, the stock will probably go up, just like most stocks go up over a long enough time frame.
I do feel comfortable saying that for those who are participating in the Netflix Supplemental Stock Option Plan, if you understand the high-risk, high-reward nature of buying options in the first place, then you should probably continue holding on for that high-reward upside or until you get closer to expiration.
Several of my options got the 40% increase needed to make up for the cost.
Netflix employees have been going on a wild ride over the last few years. When I first wrote about the Netflix Supplemental Stock Option Plan (SOP) in 2020, the stock price was fluctuating around $500 after increasing by 40% per year for a while. For those who made the decision to participate in 2021, they saw the stock price soar past $600 all the way up to $690. Just a little more and all those options around $500 would go past the 40% return they needed to break even. Many felt good about choosing to allocate large chunks of their income to the SOP. Then the stock dropped by over 70% in the following six months.
This drop made all the options purchased in 2021 worthless. Well, not worthless, just out-of-the-money, which is a key distinction I am foreshadowing for later. But Netflix employees felt ok, because now all the options purchased in 2022 were going to be at much lower exercise prices. Netflix stock doesn’t even need to go back up to its previous highs to make these options worth something. It should be easier to get the 40% increase over the next ten years to make up for the cost of the options.
And now, with NFLX over $360, many of the options purchased in 2022 have made up for their cost by seeing the stock jump 40+%. In fact, for options purchase in May, June, and July of 2022, the current price even exceeds the 67% return needed for the options to be worth more than the opportunity cost. Having gone through and knowing what a 70% drop feels like, it makes sense to want to cash out. It’s understandable that you want to lock in a gain. However, getting the same return you could have earned buying the stock kind of negates the purpose of buying the options in the first place.
Getting the same return you could have earned buying the stock kind of negates the purpose of buying the options in the first place.
Maybe you didn’t quite understand how risky these options could be. Or couldn’t predict how you would feel seeing such a drop. If that’s the case participating in the Stock Option Plan may not be appropriate for you. It is ok to take the money that would have put in the SOP and invest in in a low-cost, diversified Vanguard Total Stock Market Index Fund.
But if you’re reading this article, I hope it means you read my previous article explaining the Netflix SOP, and you do understand the risks. You are comfortable with the possibility of these options never being worth anything because you are pursuing the greater upside options provide.
So if you shouldn’t sell your options purchased in 2022, when should you? How do we decide?
This is where we need to understand two concepts; leverage and the time value of the options.
Leverage
For each individual option, because the exercise price stays fixed as the stock price goes up, we actually get an amplification of the return compared to simply buying the stock. The closer the stock price is to the exercise price, the greater the leverage and amplification of return.
For example:
If you have options with a strike price of $1.00 and a current FMV of $2.00, you currently have 2-1 leverage, so if the share price goes up 50% (from $2 to $3), you get a 100% return (your in-the-money value goes from $1 to $2).
As the share price goes up and the spread increases, the effect of the leverage diminishes. The 33% increase in FMV from $3 to $4 only provides a 50% return on the option (from $2 to $3).
And when you get to the point where the majority of the option value is in the money (such as a strike price of $1 and a FMV of $10), the benefit of leverage becomes significantly reduced. Now, a 20% increase in the FMV corresponds to 22% increase in the option spread value.
This creates a spectrum where the two ends are easy decisions. If the exercise price = the stock price, we have all the leverage, don’t exercise or sell. If the exercise price is 10% of the stock price, the leverage is basically gone, go ahead and exercise or sell. But where in the middle do we switch from holding the option to selling? I called it a spectrum, because there isn’t really a “right” answer, you can be a little more conservative or aggressive. You can calculate the leverage for different options with different exercise prices to determine which ones you should sell and which you should hold. Understanding the leverage options provide allows you to make this decision for yourself.
Leverage high -> hold
Leverage low -> exercise and/or sell
In conversations with other financial advisors, there is some agreement that an acceptable rule of thumb would be if the exercise price is 40% of the stock price or lower, this could be a transition to lower leverage and an appropriate time to sell. This would mean the stock has increased 2.5 times the original exercise price and while there is still some room for upside, the benefit of the reduced leverage may no longer outweigh the downside risk.
Rule of thumb
If the exercise price is greater than 40% of the stock price, continue to hold the option.
For Netflix options purchased in 2022, if the lowest exercise price is $179 from July 2022, you may want to wait until the stock gets over $447.50 before selling this specific option.
At a $360 stock price, the leverage is still high enough for any option granted since 2018. If you have an option granted 2017 or earlier, not only is the leverage low enough, but you are at least six years into a 10 year expiration window….which brings us to the other consideration…
Time Value
Remember earlier when I said all the options purchased in 2021 weren’t worthless? If you log in and look at the Est. Market Value, all of these options say $0.00, but the options still have some value.
One of the biggest benefit of holding stock options is that you have time to wait and see what happens without incurring any taxes or additional cost.
For the options purchased in 2021, you still have eight years before you need to make a decision. There is value in this benefit. Now, you don’t want to wait until the day before they expire, because you’ll be forced to take whatever the price is at that time. When you get within a few years of expiration, you want to start examining the leverage and a few other factors (liquidity need, concentration risk, etc.) and develop a plan for cashing out.
Example: three years before expiration, sell 25% of your options with the lowest leverage. If the price goes up to a certain target in the next year, sell 50%. If the price goes down below an acceptable level, sell 10%.
Again, there is no hard and fast rule, but you understand the two ends of the spectrum. If you have many years, you can wait, but you don’t want to get stuck at the end just before expiration. You want to gradually exercise or sell the options over the last few years.
Unlike the leverage aspect, there isn’t really a single number or date that works in a rule of thumb. But, financial markets have been trading options long enough that we can actually quantify how much the time value is worth.
This is going to get really technical, really fast, I apologize. If you understand the concept and want to quit here, I have no hard feelings.
Many years until expiration -> Wait and see what happens.
Few years until expiration -> Develop a plan for how much to sell and when.
If you have an option with an exercise price of $200 and the current stock price is $360 and you have eight years before it expires, based on the high leverage we still have it makes sense to hold on to the option.
But if you have an option with an exercise price of $200 and the current stock price is $360 and you only have one year before it expires, it intuitively makes sense to cash in that option in case the stock price goes down over the next year. Same exercise price, same stock price, two different conclusions. And it is possible to quantify that intuition.
If you cashed out each, you would net $160. ($360-$200) This is your In-The-Money value.
You may remember from my previous article that I used the Black-Scholes model to determine that the options were fairly priced, depending on my assumptions at the time. The Black-Scholes model takes into consideration how much time is left before expiration, along with the exercise price, current stock price, volatility, and an annual risk-free interest rate. When you first purchase the option (or it is granted to you) and the exercise price equals the stock price, the In-The-Money value is $0. All of the value of the option comes from the future time value.
I am using this Black-Scholes Calculator provided by myStockOptions.com to calculate the total value of the option. There are more advanced options calculators, but this works just fine for our purposes.
Inputs:
Stock Price 360
Exercise Price 200
Time to Maturity 9 years
Risk-free interest rate 3%
(We could also consider increasing the volatility to 50%, but greater volatility makes the future time-value even more valuable and I would rather be more conservative when trying to analyze the options.)
The total value of this option is $237.34. We already know the In-The-Money value is $160. This allows us to determine that the Time Value is $77.34.
If we change the Time to Maturity to 1 year, the total value of the option is $167.81 and the Time Value is $7.81. If we are close to expiration, there is much less of a chance that the option will be worth more than it is today, compared to the option that still has nine years before expiration.
Bill Dillhoefer of stockopter.com has coined the phrase Insight Ratio® where we divide the Time Value by the total value of the option to figure out what percentage of the total value is attributable to the future potential. A brand-new option will have 100% of the value attributable to the future Time Value. In our example with nine years left, the Insight Ratio® is 33%. With only one year left, the Time Value only makes up 5% of the value of the option. Similar to looking at the leverage, the decision to hold or sell by looking at the Insight Ratio® is on a spectrum between definitely hold at 100% and definitely sell as it gets close to 0%. For most people in most circumstances, it probably makes sense to consider selling the option when the Insight Ratio® is below 20%.
Consider selling the option when the Insight Ratio® is below 20%.
For Netflix employees with an exercise price of $179 from July 2022:
Total Value of the option $247
In-The-Money Value $181 (at $360 stock price)
Time-Value $66
Insight Ratio® 27%
The Insight Ratio® does a great job accounting for both the increase in In-The-Money value and how much time is left on the option. It makes sense to hold on to this option at this time. As the stock price goes up OR we get closer to expiration, the Insight Ratio® will drop.
For the option with an exercise price of $179 and 9 years left, the stock price would need to get around $435 for the Insight Ratio® to get below 20%. If the stock price remains at $360, we would need to wait until there are 5 years remaining before expiration for the Insight Ratio® to drop below 20%. All other options purchased in 2022 have a lower In-The-Money value and are further from selling consideration.
Options granted 2017 or earlier -> probably ok to Sell
Options granted or purchased 2018-2021 -> high leverage or out-of-the-money -> Hold
Options purchased 2022 -> high leverage AND high Time Value -> Hold
Based on both the leverage AND the Insight Ratio®, it probably makes sense to hold on to the Netflix stock options purchased in 2022.
If you have any questions, please feel free to email me at aaron.agte@graystoneadvisor.com or schedule a meeting.
Aaron Agte, CFP®, founder of Graystone Advisor, is a fee-only Financial Planner located in Foster City, CA, serving clients virtually in the Bay Area and across the country. He specializes in helping families with stock options, RSUs, and other equity compensation.
@AaronAgteCFP