stock options and stock buybacks

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.

My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.


After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.



calls and puts on stocks: simple derivative instruments

In a recent post on the Macau gambling industry, I wrote that I had sold covered calls on WYNN, something I said I never would have done as a professional portfolio manager.

I want to explain what I’ve done, why, and why I’m willing to do it now when I wouldn’t do it then.

I’m going to do so in two posts.  Today I’m going to write about what (American) options are and the mechanics of buying and selling.  Tomorrow, I’ll write about why.

what they are: tons of terminology

As with most areas of finance, the basic ideas behind options are relatively simple.  Things get complicated, however, because there’s jargon to learn and because the markets can’t resist the urge to tweak the basics a bit to offer something slightly different.  As time progresses, the steady accumulation of simple tweaks creates the impression of incredible complexity, when it’s only simple ideas applied numerous times.

Here’s my attempt to untangle the options story:


Derivative instruments are securities whose value derives from that of some other, benchmark, security.

Stock options are a type of derivative contract.  Options give the holder the right–but not the obligation–to transact in a given stock during a specified time period.

Calls give the holder the right to buy the underlying stock from the person on the other side of the contract at the specified price.

Puts give the holder the right to sell the underlying stock to the person on the other side at the specified price.

American-style stock options are exercisable at any time during the life of the contract; European-style (I’ve never owned one) are exercisable only at expiration.

Most stock options in the US are exchange-traded; that is, they have uniform characteristics and are regulated/guaranteed by the Options Clearing Corporation, which matches buyers and sellers.  There are also over-the-counter options, which are private contracts between an investor and an investment banker, but this isn’t anything we need to worry about.

The OCC has established standard contracts for options.  Under normal circumstances, contracts:

–involve 100 shares of the underlying stock

–have an exercise or strike price that’s set at a standard amount and at a specified interval from other options on the same stock, usually $5, and

–expire at a standard time during the third week of the month.

buying and selling

Not everyone can buy and sell options.  You have to satisfy your broker, usually by filling out a standard form, that you understand the risks of options trading and have the means to settle any trades you may make.

four possibilities

There are four possible positions for an options trader to be in:

1.  long a call, meaning you own the right to buy a given stock at the specified price,

2.  short a call, meaning you have agreed to sell the stock in question at the specified price to a buyer in the #1 position, if he exercises his right.

3.  long a put, meaning you have the right to sell the given stock to the person on the other side of the contract at the specified price.

4.  short a put, meaning you have the obligation to buy the stock in question at the specified price, if the buyer in #3 exercises his right.

In cases 2 and 4, the trader has to  set aside collateral to show he can satisfy his obligation, if need be.  In the case of the seller of the call (#2), he may already own the stock in question.  If so, he is said to be selling a covered call, meaning he can satisfy his obligation by delivering the stock he owns to the buyer.  The stock is his collateral.

finding prices

If you get a price quote and chart for any stock on Google, Yahoo or on your broker’s website, there should be a link on the page that’s labelled “option chain.”  Clicking that will get you a list of all the available puts and calls on the stock, organized by expiration date and by strike price.

The list will show you the last trade, the bid-asked spread, today’s volume, and the “open interest,” meaning the total number of contracts outstanding for that strike price and expiration date.  The prices shown will be per share amounts, so you have to multiply that number by 100 to get the total dollar amount involved in buying or selling a single contract.


Professional options traders use highly complex mathematical models to price options.  The main components of valuation end up being the volatility of the stock in question and the time remaining until the expiration date.

In very simple terms, value can also be separated into two components:

— intrinsic value, meaning any portion of the option price accounted for by the price of the underlying stock.  Example:  if the option strike price is $25, the option is trading for $5 and the stock is trading at $28, the option would have $3 in intrinsic value.

time value, meaning anything other than intrinsic value.  In the case above, time value would be $2.

That’s (more than) enough for today.  Tomorrow’s post will be on using this information.