McGuire in and were also dated on the day with oa years' single lowest closing price. A grant in came near the bottom of a sharp stock dip. In all, the odds of such a favorable pattern occurring by chance would be one in million or greater.
Differences between Call Options and Put Options
Odds such as those are "astronomical," said David Yermack, an associate professor of finance at New York University, who reviewed the Journal's methodology and has studied options-timing issues. Options grants are made by directors, with details often handled by a compensation committee. Many companies make their grants at the same time each year, a policy that limits the potential for date fudging. But no law requires this. Until last year, UnitedHealth had a very unusual policy: It let Dr. McGuire choose the day of his own option grants. According to his employment agreement, he is supposed to choose dates by giving "oral notification" to the chairman of the company's compensation committee.
The agreement says the exercise price shall be the stock's closing price on the date the grants are issued. Arthur Meyers, an executive-compensation attorney with Seyfarth Shaw LLP in Boston, said a contract such as that sounded "like a thinly disguised attempt to pick the lowest grant price possible. Meyers said such a pact could pose several legal issues, possibly violating Internal Revenue Service and stock-exchange listing rules that require directors to set a CEO's compensation. It's just not good corporate governance.
William Spears, a member of UnitedHealth's compensation committee, said the October grant wasn't backdated but was awarded concurrently with the signing of Dr.
What Is a Put Option? - TheStreet Definition
McGuire's employment contract. Spears said a depressed stock price spurred directors to wrap up negotiations Wzll get options to ootion. The board revised terms of the employment contract last year and will start making stock-option grants at a regular time each year, Mr. Spears added. The SEC's look at options timing was largely prompted by academic research aWll examined thousands of companies and found odd stgeet of optoin movement around the opttion of grants. One study was by Erik Lie of the University of Iowa. He found that share prices puut fell before option grants and rose pu, with the result that recipients got options at favorable times.
He concluded this was so unlikely to happen by chance that at least some grant dates had to have opton filled in retroactively. Another possible explanation for big rises in stock prices following grants is that executives knew favorable company news opption coming and timed the grants just before it. But academics think timing for company news is a less likely explanation for the patterns, given the consistency of the stock climbs after grant dates. Also, for many of the companies the Journal examined, no obvious company news followed closely upon the option grants. It's also possible companies sometimes award options after their stock has taken a fall and seems to them to be undervalued.
In point of fact, the companies can't possibly know what the stock will do next, but that doesn't mean they might not feel confident enough about a recovery to think they are hitting a favorable time to grant options. As dot-com and telecom shares exploded, stock options became a source of vast wealth. They also grew controversial. Critics worried that big options grants tempted executives to do whatever it took to get the stock price up, at least long enough to cash in their options. At the same time, during a general bull market, the options sometimes richly rewarded executives for stock buoyancy that had little to do with their own efforts.
At Mercury Interactive Corp. Mercury said an internal probe found 49 cases where the reported date of options grants differed from the date when the options appeared to have been awarded. The company said it will have to restate financial results. The SEC is still looking at Mercury, said someone familiar with the situation. Analog Devices Inc. It neither admitted nor denied that it had misdated options or had made grants just before releasing good news that would tend to push up the stock. The Norwood, Mass. Analog didn't make him available for comment. The company said it will not restate its financial records.
In some instances, backdating wouldn't be possible without inattentive directors, securities lawyers say. At one company the SEC is looking at, lawyers say, it appears that someone picked a favorable past date for an option grant and gave it to directors for retroactive approval, perhaps counting on them not to notice.
In another case, the lawyers say, a space for the grant date appears to have been left blank on paperwork Wall street option put ka by directors, or dates dtreet later altered. Untilcompanies didn't have to report option grants until months later. The Sarbanes-Oxley law, by forcing them to report grants within potion days, left less leeway to retroactively date a grant. The new rule reduced stock patterns suggestive of backdating, but didn't eliminate these altogether, optiin to a study by M. Narayanan and H. Nejat Seyhun of the University of Walp. They found that puut report about a quarter of option stredt later than the two-day deadline -- and that such delayed reporting is associated with big price gains after the grant dates.
It optionn a pattern Ztreet. Wall street option put ka calls "consistent with backdating. The stated grant date stdeet May That was a lption day to have options priced. Therrien's May options activity optikn no mention of his having gotten a optioon on May 31, even though the report -- which Mr. Therrien signed -- did cite other options-related actions he took on May It wasn't the only well-timed stret grant he got. One in October came at Brooks stock's lowest closing price that year, once again at the nadir of a sharp plunge.
Opfion Journal analysis puts the odds of such a consistent pattern occurring by chance at about 1 in nine million. Therrien, who stepped down as CEO in and retired as chairman this month, didn't return messages seeking comment. Chief Financial Officer Robert Woodbury said Brooks is "in the process of revamping" practices so grants come at about the same time each year. Woodbury, who joined insaid no one at Brooks would be able to explain the timing of Mr. Therrien's grants. Although Brooks directors typically got options only in July, that year a special grant was awarded just to these two directors, Roger Emerick and Amin J. Another company, Comverse Technology Inc.
The announcement reversed a prior Comverse statement -- given a week earlier in response to Journal inquiries -- saying all grants were made in accordance with applicable laws and regulations. The Journal's analysis spotlighted an unusual pattern of grants to Kobi Alexander, chief executive of the New York maker of telecom systems and software. Another grant, on Oct. Others also corresponded to price dips. The odds of such a pattern occurring by chance are around 1 in six billion, according to the Journal's analysis. Before Comverse announced its internal probe, John Friedman, a member of the board's compensation committee, said directors had noticed the scattered nature of the grants -- eight between and fell in six different months -- but management assured them there were valid reasons.
Alexander, the CEO, didn't return phone calls. This week, Comverse said that, as a result of the board's review of its options grants, it expects it will need to restate past financial results. Propitious option timing can help build fortunes even at companies where the stock doesn't steadily rise. Shares of Vitesse Semiconductor Corp. But Louis R. Tomasetta, chief executive of the Camarillo, Calif. The date they were priced coincided with a steep fall in Vitesse's stock, to what turned out to be its low for the year. In eight of Mr. Tomasetta's nine option grants from tothe grants were dated just before double-digit price surges in the next 20 trading days. The odds of such a pattern occurring by chance are about one in 26 billion.
Alex Daly, a member of the Vitesse board's compensation committee, said a review of the grants found "nothing extraordinary" about their timing, and "absolutely no grants have been made to anyone, least of all the CEO, that are out of sequence with our normal grant policy. Tomasetta said the grants were "approved by the board and the price set at the close of the day of approval. ACS handles paperwork, accounting and data for businesses and government agencies. It is a major outsourcer, relying on global labor. Rich told the University of Michigan business school in"but there is a lot of money in boring.
Rich's stock-option gains were due to rises in ACS stock, the exceptional timing of grants enhanced his take. An especially well-timed grant, in which Mr. This happened to be the bottom Waol a ootion plunge in the price. ACS's Ms. Pool said the grant street for Mr. Rich's promotion kaa CEO. He wasn't promoted optoon February Pool said there was a "six-month transition optipn and the Oct. Rich would have fared far worse had his grant come Wakl the day ACS announced his promotion. The stock by then Wal, more than twice as high. The grant wasn't reported sgreet the SEC until 10 months after the stated grant date.
Pool said that was proper under regulations in place at the time. A special board committee oversaw Mr. Rich's grants. Rossi declined to comment. O'Neill Wal, "We had ups and downs in our stock price like any publicly traded stock. If there were perceived low points, would we grant options at that point? Rich said grants were made strdet the opiton the compensation committee ztreet them, or within a day or so of that. He said he or Chairman Darwin Deason made recommendations to the special board committee about option dates. Rich, who is 45 syreet old, resigned abruptly Walp ACS's chief executive on a Thursday in September to "pursue other business interests.
But the company didn't announce the resignation that day. Rich said ACS signed his separation agreement on WWall, using Thursday's price for the options payout. He Wall street option put ka it waited till Monday to release the news pption it didn't want to seem "evasive" out putting the news out late Friday. Reload, Reprice, Backdate Eugene Isenberg is the little-known chief executive of a modest-sized oil-services company in Houston. But he stands out in one way: He is among the highest-paid corporate executives in history. The key to this wealth: His employer, Nabors Industries Ltd. They became lucrative partly because of Nabors's generally rising stock price, but also because of some controversial moves that gave the options more punch.
When Nabors's stock fell below the price at which the options could be exercised, temporarily making them worthless, Nabors let him trade in some of his options for new ones with lower exercise prices. And when Mr. Isenberg cashed some options in, Nabors "reloaded" him, replacing those he'd exercised with the same number of new ones. Stock options were hailed two decades ago as a remedy for runaway executive pay. Academics, politicians and investors, tired of seeing CEOs pocket big money for a so-so job, pushed to have stock options become a primary method of compensating executives. Options -- granting the right to buy stock tomorrow at today's price -- would pay off only if the company's stock went up.
To advocates they were the ideal carrot, an incentive for good work that aligned executives' interests with those of shareholders. That happened -- sometimes. But at many companies, options morphed into the biggest executive bonanza yet, pouring out cash like a stuck ATM, and sorely disappointing those who thought options would moderate executive pay. Instead of replacing big bonuses, options became an additional form of pay slathered on top of already-generous packages. Employers doled out options in ever-growing numbers, in part because, until recently, accounting rules meant companies didn't have to treat this largess to executives as an expense.
And like Nabors, some used repricing, reloading and other tactics that made it even easier for executives to score huge hauls. This year, options practices exploded in one of the biggest corporate-fraud scandals in decades. Some companies and executives stole from shareholders, by pretending that options had been issued earlier than they really were, at more favorable prices. At least U. Some have admitted to it. More than 60 executives and directors of public companies have lost their jobs so far, 17 of them chief executive officers. After probable backdating was exposed at giant insurer UnitedHealth Group Inc.
Nabors's Mr. Isenberg offers an example of the huge wealth CEOs have gained through stock options. Now, some of his option grants appear to raise questions about how they were dated. A number came on days when the stock hit its lowest close for the month or the quarter. At other companies, a series of low-price grants has been a pattern that has suggested possible dating problems. At the least, the favorable grant dates added to Mr. Isenberg's mammoth options gains. A spokesman for Nabors said its legal department did an internal review and found "no irregularities in its grant practices.
Some of the documents bolster that assertion. The spokesman, citing Mr. Isenberg is appropriately compensated. Nell Minow, a longtime corporate-governance advocate, calls backdating "just another in an endless and unstoppable series of mechanisms to subvert the purpose of stock options. Minow now regrets that stance. Murphy of the University of Southern California. The result was that options, which in made up less than a quarter of the average CEO's pay, by provided more than half of pay packages -- packages that were much larger. Companies have started doling out fewer options in the past few years, but grants remain far more generous than a decade ago.
Defenders of options, who remain numerous, say options shouldn't be judged by a few giant packages. Many companies have given out options judiciously, say defenders, some of whom attribute rising executive pay to tight competition for top managers. Others say stock options have helped to foster innovation, by giving young but cash-poor companies a currency with which to attract talent.
Some supporters of options even give them partial credit for the long bull market that began infiguring that options help focus top executives on the key issue for shareholders: Frederic W. Cook, a New York compensation Wall street option put ka, calls the stock option "the most perfect equity derivative that's ever been invented: It's simple, elegant, easily understood, and it gives you a little piece of the action. Options usually don't "vest," or become exercisable, for at least a year after they're granted. Stock options appeared at least as early as the s, says Carola Frydman, an assistant professor of finance at Massachusetts Institute of Technology who has studied the history of executive pay.
The modern era began inwhen Congress, reversing a court ruling, gave options substantial tax advantages over ordinary income. By the middle of that decade, they accounted for nearly a third of CEO compensation at large industrial companies. One reason was public fury over mammoth executive paydays for bosses with just average performance. In an influential Harvard Business Review article, Mr. Murphy and Michael C. Jensen said the problem was executives were paid like "bureaucrats" instead of entrepreneurs. They called for giving "big rewards for superior performance and big penalties for poor performance.
Murphy says today. But "that's not what companies ended up doing. They layered on massive amounts of options on top of the rest. First, it passed a law, pushed by President Clinton, seeking to rein in executive pay by limiting the tax break for it. But it exempted certain kinds of pay linked to performance, which included stock options. Companies rushed to restructure pay plans to grant more options. Murphy, and nearly doubled again over the next two years. The law "deserves pride of place in the Museum of Unintended Consequences," said Christopher Cox, chairman of the Securities and Exchange Commission, this fall. Then inCongress helped beat back a proposed rule requiring companies to treat a stock-option grant as an expense and deduct it from profits.
The plan, backed by the SEC and accounting rule makers, sparked intense corporate opposition. Congress stepped in to fight it, and after a long battle, the accounting rule makers caved. They issued a watered-down rule saying all that companies had to do was disclose in a footnote what options would have done to their profits, had the proposal passed. Meanwhile, Congress left alone an older law that gave companies a tax deduction whenever stock options were exercised. Under that rule, which applied to the most common type of option given to executives, the employer can deduct a dollar from its income for tax purposes for every dollar of option gains pocketed by employees.
With rules like these, "what wasn't there to like about a stock option? One was the "Lake Wobegon effect," named for the mythical Minnesota town in radio host Garrison Keillor's world where all the children are above average. Many boards believed their chiefs should be paid at least as much as the average in their industry, and often more. That attitude had the effect of pushing this average up, year after year. Another force largely escaped notice because it seemed benign. This was a tendency by companies to grant top executives the same number of options each year, or more, even if the stock price had risen.
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During a bull market, doing so kept raising the value of pay packages. In ja to give this executive an option grant of merely the same value in year two as in year one, the year-two grant would have to contain far fewer options. Directors had a hard time telling a CEO they were cutting the number of ptu because the stock had risen. Todd says the CEO's reaction would be, "I worked to get the stock price up, and my next grant is smaller and has a higher strike price? Over that period, the stock rose sharply. The calculation used a standard formula for valuing options known as "Black-Scholes," which sets a value for a grant at the time it's given by estimating how much gain it will someday bring the recipient.
An Exxon Mobil Corp. AfterExxon replaced options grants with restricted stock, a different form of compensation that the board said was "more effective in aligning executives' interests with those of shareholders. Raymond retired a year ago. At times, the value of options companies doled out has been equal to a large share of their profits. Jeffries, of course. But it incurred an obligation to issue 4.
kaa And Wlal obligation didn't have to be reflected as an expense on the company's income statement. A spokesman for Abercrombie said the grant had a "delayed ophion feature "intended to incentivize Mike Jeffries to remain with the company The options-issuing frenzy reached a peak in and Dot-com companies, some with little other way to pay employees, handed out options like confetti. Thousands of people made fortunes on stratospheric rises in the stocks of tech firms, some of which didn't exist a couple of years later.
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The Federal Reserve's then-chairman spoke of an "infectious greed" that seemed to grip some in business, for which he partly blamed "poorly optiob stock options. Giant grants "perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and Wqll he said. If Wll share price fell well below syreet options' exercise price, they simply lowered that price. Companies defended puh move by saying options far "under water" or "out of the money" no longer served as incentives to executives to perform pjt.
Critics of repricing say it subverts the fundamental options purpose of aligning managers' and shareholders' interests. Since lut can't get a refund on a stock they bought that has fallen, the critics say, why should executives be able opiton do something similar? Repricings "basically ensure that the manager gets paid no matter what. It takes streeet lot of risk out of the stret thing," says David Yermack, a New York University professor who studies executive pay. Borland Software Corp. System Software Associates Inc. Subramaniam says. Ina change in accounting rules crimped repricing somewhat.
Strete now had to take a hefty charge against earnings if they put new exercise prices on existing options. But there was stteet loophole. If they canceled k old sfreet, waited six months and issued new ones at a lower price, there was no penalty. As tech la collapsed in the early s, directors rushed to shore up optioh stranded out of the money. Many shareholders fell hard. The boss optino a softer landing. Between Etreet and Optipnthe company repriced 1. PMC-Sierra Wxll the figures but had no other comment. Lock and Reload In the late '80s streeet early '90s, companies found another way to puh stock-option grants: Normally, options disappear when exercised. But with a reload plan, a person who exercises options pjt gets replacements.
Typically the replacements number fewer than the options exercised. They carry the ptu expiration date but a different exercise price -- the current market price. Reload plans streef supposed to encourage executives to hold stock in their company, out Mr. Cook, the pay consultant, who invented them. To get a reload, executives exercising options generally pht do so optiion with cash, but kx stock. That is, they must hand in existing shares whose value equals the cost of exercising the options. Since executives can't do that unless they own shares, they have an incentive to be shareholders of the company and to hold onto new shares obtained when they exercise options.
Critics decried reloads as abusive, a kind of option puf machine that enriched top managers -- while diluting other stockholders' ownership as the number of shares outstanding rose. The first reload plan appeared in strreet late s. Byaccording to Mr. Cook's firm, nearly a fifth of large companies ootion offering them. Inshareholders of his company, then called Primerica Corp. Deep into the legalese, on page 17, was a clause that would prove extremely lucrative puf Mr. The reload plan applied to previously issued options, including a giant grant Mr. Weill got in The plan initially also had an unusual element. Any options issued as a result of reloads wouldn't expire on potion options' old expiration date, but could carry a new year srteet.
Not long after the plan was adopted, Mr. He then received replacements for most of them, restarting the streeh with 10 more years to run. Year after year Mr. Weill exercised some of the replacements, each time getting more new options -- some of Wall street option put ka he then exercised, once again getting more replacement options, and so forth. From through the strest of last year, Mr. Shareholders did extremely well, too. As of yesterday, the stock of Citigroup and its predecessors was more than 30 times the price in the public offering of Mr. Weill's original company. A Citigroup spokesman, Michael Hanretta, said Mr. Weill's options were so valuable because the company "created superior shareholder value.
Weill was required by company policy to hold onto all or most of his shares. Reloads have died out in recent years, after new accounting rules made them too costly to issue. A separate rule also made it financially prohibitive to add a reload feature retroactively -- eight years after Mr. Weill got that benefit. Other rule changes have also helped slow the options express. Besides a requirement for prompt disclosure of grants, a new accounting rule means companies must record an expense when they make an options grant, and reduce profits accordingly. Many companies have cut back on options, and some have stopped awarding them at all, often replacing them with grants of shares.
Deep Well Over the years, few corporate executives have availed themselves more thoroughly of what options have to offer than Nabors's Mr. Still chief executive at the age of 77, Mr. Isenberg lives in the Breakers resort complex in Palm Beach, Fla. A generous donor, he has helped found a school in New York for children with learning disabilities and given millions to the University of Massachusetts at Amherst, which has named its business school after him. Isenberg worked at Exxon for 13 years and then headed a small steel company, settling into early retirement after that firm was sold in He was persuaded to rejoin the business world by his friend Martin Whitman, a prominent New York investor, whose fund had taken control of a troubled oil-services company called Anglo Energy.
Isenberg invested some of his own money and in took the helm of what was soon renamed Nabors Industries. Early on, Mr. It was the first in a series of deals that "made the company," said the Nabors spokesman, Denny Smith. Its stock has risen at a lush An employment contract Mr. Isenberg got when Nabors emerged from bankruptcy entitled him to an annual bonus equaling a percentage of the company's cash flow above a threshold. Nearly two decades later, Nabors is long out of bankruptcy but has continued to renew this unusual percentage-of-cash-flow deal, albeit with less-generous formulas.
Rather than accept all his bonuses, Mr. Isenberg in many years declined part of them in favor of stock options. By Nabors's reckoning, his option grants were worth tens of millions of dollars in some years. Smith, the spokesman, said this acceptance of options instead of cash meant Mr. Isenberg was placing a big chunk of already-earned pay "at risk, in alignment with shareholder interests. For a time, Nabors operated under an options "reload" plan. It was a generous one: Instead of replacing only a portion of options that were exercised, it replaced them one-for-one. Isenberg could cash in options and take profits yet still have just as many options as before, though with higher exercise prices.
In another atypical feature, the replacement options sometimes had new terms of 10 years, making them even more valuable. Nabors says it stopped reloads before But in that year it gave Mr. Isenberg a "special award" of 2. Share figures in this article aren't adjusted for a recent two-for-one stock split. Thus one would most likely find a retail investor buying an option where the return could be infinite but probability would be low. But an institutional investor would typically be taking the other side of the trade where the risks are low and so are the returns. The fact that institution investors generally come out victorious can be judged from the fact that more than 90 per cent of the options normally end up worthless.
Thus a retail investor who would have bought an option would lose his entire money while an institutional investor would walk away with the small profit from the trade. If it is any consolation then the ratio of percentage is valid even for the cash market, except the time frame is longer. Only 10 per cent of investors have made money in the markets over the medium to long term. New investors are attracted to the market with the promise of quick buck but lose out without understanding the game. The question is, in the option market what does it take to be in the 10 per cent trades which are winners.
One way in ensuring success is to avoid mistakes, at least the most common ones. Highlighted here are some of the key mistakes a trader makes in the option market which are pulling him down. Many traders jump into option trading without really understanding the reasons behind the movement of options or the maths behind it. Little attention is paid to details like how much does an option move with respect to the underlying share or index, the Greeks that are used for calculation of option prices. Generally few traders know which strike price will offer the best risk reward trading opportunity is case of a small move or large ones.
Lack of understanding options results in retail traders buying options which are out of the money for the simple reason that they are cheap. An occasional win trade results in the trader getting fixated to buying out of the money options. In most cases even when the trader is right in his trade he loses money in the out-of-the-money trade since it requires a very sharp and fast move for these options to become profitable. It has been found out that trading in out of the money options is one of the biggest reasons for option trader loses. Option strategies are rarely understood and investors end up trading in vanilla call and put options and losing money in the process.
These days many brokerages offer option trading strategies to choose from, making it easier for investors to select, but few investors utilise these services. Traders lose money because they do not know when to exit from an option position even if they are right. The fact that holding on to a position as time passes, erodes the value of the option is rarely understood. Similarly since the amount involved in options is small traders do not trigger the stop losses. They tend to hold to the trade in the hope that a move in their direction will result in a profitable exit. Ones an option goes out of the money as the underlying stock or index moves away from it, it would require a big move for it to come back to its breakeven level.
Option prices tend to over-react when an event is approaching. Investors read the rising value in options as a sign of a big move in its direction. Movement in option prices at the time of Infosys results announcement is the best example of how they rise without any appreciable rise in the underlying. Rising option prices is the premium that is being built in anticipation of a sharp move in either direction. Many times novice trader tries to behave like a professional trader and gets in the act of writing option where returns are limited while risk is unlimited.