Options are a tremendous tool for financial management. There are four primary ways that companies use them -- hedging, speculation, arbitrage, and compensation. Three of the four are fabulous ideas. It's the abuse of the fourth that spoils the party for investors.
Let's start with the best, most basic use of options -- hedging. Hedging is a great, relatively low-cost way for companies to reduce their financial risks. A few years back, banana titan Chiquita Brands (NYSE: CQB ) went through a bankruptcy. While there were many factors leading up to that bankruptcy, part of the problem was the then-rapidly appreciating dollar. With so much of its supply coming from Latin American countries and so much of its revenue coming from the euro-zone, Chiquita faces very real currency risks -- including the possibility of losing money on what should have been profitable sales -- thanks to currency fluctuations. By now more aggressively buying options to hedge those risks, Chiquita has much better capacity to react and adjust to such fluctuations, thus reducing the risks of another bankruptcy.
Of course, for every option hedge buyer looking to reduce risk out there, there has to be a counterparty willing to accept that risk. That counterparty engages in speculation, which is the act of taking on additional risk for the hope of achieving a reward. For the most part, counterparty speculators are financial institutions, such as Citigroup (NYSE: C ) , with both the wherewithal to stomach it and the financial acumen to assure that they charge a sufficient premium to adequately compensate them for that risk. In fact, since options hedgers are willing to pay a certain, small cost now to avoid an unknown, potentially large cost later, those counterparty speculators very often end up profiting from their risks.
Along with hedgers and speculators are another group, arbitrageurs -- people and companies looking to earn risk-free profits by trading on the market's inefficiencies. Arbitrage trading not only makes risk-free profits for its practitioners (companies like Morgan Stanley's (NYSE: MWD ) investment arm), but it also serves a beneficial purpose for the market itself. By their actions, arbitrage traders act as the options market's natural referees, adding both liquidity and efficiency to the options market. That makes that market a fairer priced, less-expensive place for hedgers and speculators to do their business.
One bad apple
Hedging, speculation, and arbitrage are fabulous processes enabled by options. They help companies quantify, transfer, and prepare in advance for financial risks that may face them. Unfortunately, in their other big use -- as part of executives' compensation programs, options often cause more problems than they're worth. The reason? They create perverse incentives.
Unlike an actual shareholder, an employee option holder has no risk of loss. At the time the options are granted, they're usually at-the-money and therefore have no intrinsic value. Their exercise value cannot be worth less than on the day they're granted. On the other hand, they can go up in value only if the company's stock price moves up before the option expires. This leads executives of options-happy companies to do whatever it takes to get the stock price up quickly, so their options are worth the most possible value.
Notice I said stock price -- not business value, not corporate dividends, not shareholder wealth. There are all sorts of games executives can play to boost a company's stock price in the short run. Some are legal, some are hard to catch, and some work wonders in the near term but utterly destroy a company's operations over time (see Enron). One of my least favorite, though perfectly legal, techniques is the shareholder-equity-destroying buyback of a company's overpriced stock. Technology giant Cisco Systems (Nasdaq: CSCO ) is a master of that technique, and as I pointed out in a previous duel, literally billions of dollars of shareholder equity has evaporated in the company's vicious cycle of extremely dilutive options grants followed by aggressive share buybacks.
Let's not forget the past habits of companies like Apple Computer (Nasdaq: AAPL ) . For years, it was willing to "reprice" (lower the exercise price) of employee stock options. When that happens, the employee options holders were doubly protected from the downside of their employer's stock. Not only that, but they were actually actively rewarded for it by receiving that much larger a payday if or when the company's stock merely rebounded back to the original strike price.
The Foolish bottom line
As a tool for financial management, options are a wonderful device. Employee stock options, on the other hand, often morph into a no-risk, outsized reward mechanism that's easily abused to destroy shareholders' wealth. As a form of compensation, options do a lousy job of aligning employees' interests with that of the company's owners. Instead, they do a great job of enriching highly placed insiders who are willing to destroy their firms to pocket a quick few million bucks.
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At the time of publication, Fool contributor Chuck Saletta had no ownership stake in any of the companies mentioned in this article. The Fool has a disclosure policy.