Apple stock options analysed for riskiness

On April 2, 2012, Apple Computer moved up $19.15 which was a 3.18% gain above the $600 closing price of March 30. But the January 2013 calls with a strike price of $550 moved up 12% and the January 2013 calls with a $450 strike moved up 9%.

http://finance.yahoo.com/q/op?s=AAPL&m=2013-01

This illustrates that the stock is less volatile than the options and the options that are substantially in the money are less volatile than the options that have exercise prices close to the current market price.

The implication here is that the options that are slightly in-the-money are substantially more risky than the ones that are deeply in-the-money because of the much higher volatility of the near-the-money options.

Even if the stock is unchanged over time, the options which have exercise prices closer to the market value of the stock will lose money from erosion of the "time value" (i.e. theta) faster than those which are more-in-the-money and have less "time value". And that applies to traded options and employee stock options.

So it is 100% clear to any informed options practitioner that the ESOs that are in-the-money but have strike prices reasonably closer to the market price of the stock, have much more risk than the deep in-the-money ESOs.

Therefore if a fiduciary wants to advise the reduction of risk, he/she should look to where the risk is the highest and therefore look to the ESOs where the stock is 50% above the exercise price before the adviser looks to the ESOs where the stock is 100% above the exercise price.

But that puts the adviser in a dilemma if the adviser can only use the strategy of early exercise sell and diversify, which require high penalties for early exercises. The adviser must advise the selling of calls and to a lesser degree buying puts if he/she wants risk reduction.

If that choice is prohibited by company contract or the employee has no funds to use as collateral to support the selling of calls or buying of puts, the employee might as well just assume the risk and hold the ESOs to near expiration as Steve Jobs, James Dimon, Larry Ellison, John Chambers and other CEOs did and will do.

In rare cases, the early exercise, sell and diversify strategy may have some merit, but generally should be avoided.

John Olagues