Employee Stock Options - NQSOs & ISOs Message Board

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Strategies & Market Trends : Employee Stock Options - NQSOs & ISOs

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To: rkral who wrote (80)	6/19/2002 9:20:32 PM
From: Stock Farmer	Read Replies (1) of 786

When I described "expected future value" I very clearly defined this as the difference between what the stock is expected to be worth in the future and the strike price. I think you will note that this BY DEFINITION is equal to the sum of intrinsic value plus time premium. Simply telling me that you interpret this to mean that the time premium is equal to the expected future value is in effect merely pointless twisting of semantics. If you expect an option to be worth $5.00, and the current intrinsic value is $1.00, that makes the time premium worth $4.00. Right? Furthermore, by expecting the option to be worth $5.00 you expect the market price to be $5.00 above the market price. In present value terms. Right? Start again very simply. You write an option. You give it to me. Both of us look at it and say that we think it will be worth $5 in 5 years time. You might be mathematically precise and state that this $5 is all "time premium" because the "intrinsic value" is zero. Or maybe the intrinsic value is $3 and the time premium is $2. In the end however, the split between the two is somewhat academic when it comes to how much money lands in my pocket and how much money I extract from yours. I am far less knowledgeable and much less sophisticated about these things. I just look at it and say "I expect the thing to be worth $5". How much has that option actually cost you? You can jump up and down and claim that you have given me something "worth" $5.00 and so that act of generosity cost you $5.00 because you might have given it to someone else. Or you can say that since the future hasn't yet unfolded that you haven't really gained or lost anything, but that you expect to lose $5.00 in the future. In either case we could agree that I have something of value in my pocket, because I won't simply give it back to you without a fight. I'm not stupid. Not because I think it's got the purchasing power of a $5 bill, but because if I give it to you I'm guaranteed to get $0.00, but if I keep it I might get more. A no-downside risk no brainer. Anyway, you could quite legitimately chock up an accounting cost of $5.00 at the instant of that nice generosity. So on your ledger of assets you write (5.00) under "reserves for paying John". Fast forward five years. That cost of $5.00 you expected to incur has mushroomed to $20. Somehow you have to cough up $15 more than you expected. So you do. And you are a bit sad. But I am very happy. Because without a doubt I ended up with $20.00 The question I have for you is, looking backwards from the point of exercise, what did this option ACTUALLY cost you? A measely $5.00? Or the full $20? How do you answer? More important, how do you ACCOUNT for this deviation from expectation? John

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