Some CFOs hate the headaches listed stock options bring. But maybe they should consider the demonstrable benefits, like the valuable market insight of their options specialist.

By Tina Ruyter

It can come as a bit of a shock. Without so much as a by-your-leave, many companies are finding themselves with new relationships. In February the Philadelphia and American Stock Exchanges launched trading in the listed options of Keane, a software services company with some $400 million in annual revenues. "At first, most of us at Keane were not sure what it meant," reports Larry Vale, who runs the company's investor relations function.

Vale isn't alone. The number of U.S. companies with listed options on their stock has doubled in the last five years, to 1,700. An exchange doesn't have to ask permis-

sion before listing the options of a particular company. This lack of control worries some treasurers. But listed options bring benefits-from dampening volatility in the underlying stock to corporate visibility. And the options specialist may be able to provide valuable information and insights into the behavior of different groups of investors. A company may not have sought an options listing, but it can be turned to the company's advantage.

Whether options have brought any of their touted benefits to Liposome Co. in the five years they have been listed is an open question for Brooks Bovereaux, the company's vice president and treasurer. Liposome, a biotech company, is conducting trials on several new drugs, and has launched its first. Liposome's $16 million in revenues comes primarily from research and development agreements with major pharmaceutical manufacturers and investment income from its IPO proceeds. It is hard to tell whether volatility is less than it would have been without options, Bovereaux says. The theoretical advantage of lower volatility is a lower cost of capital. And whether lower volatility would have a measurable impact on Liposome's cost of capital is a separate question, he adds.

In fact, Bovereaux sees a risk in having listed options. He notes that options investors tend to be highly sophisticated investors who play a "higher risk game" than the larger money managers. So he wonders whether investors who buy options in his stock would buy the underlying stock instead of the options if no options existed. "It's not clear whether [the options] are driving away a group of people who might buy common stock," he says.

Pre-Paid Legal Services, a company with $37.5 million in 1995 revenues, found out that options were being listed on its stock when someone called treasurer Randy Harp after noticing a press release about the listing on a Reuters screen. "We were surprised to learn that we didn't have any control over it," Harp says. Currently, the options are listed only the Philadelphia Exchange. The American Stock Exchange, where Pre-Paid Legal Services stock is traded, also wanted to list the options but, as a courtesy, asked for the company's permission to do so. The company declined.

Defensive tactics

A company can do little to prevent an options listing other than asking the exchange to refrain as a favor. One possible sandbagging strategy would be to introduce frequent non-cash dividends. This has the effect of making the options unwieldy and expensive for the exchanges. If the options are sufficiently difficult to manage, the exchanges will cancel the listing. Of course, this also makes administration more expensive for the company.

Although an exchange official told him that an option listing is "a sign that you have arrived," Harp is bemused, not thrilled. "Our stock has done very well," he says. "My view is 'don't fix it if it ain't broke.'" In fact, if an options listing is really a badge of distinction, then it is one that Pre-Paid Legal Services has just barely achieved. It only recently met the size tests for options listing. To qualify for an options listing, a company's stock must trade above $7.50. In January 1995 the company's stock traded at $1.81; it was trading at $16 in April of this year. So far, Harp says, watching his company's options trading has been unexciting.

For many companies, options trading is usually nominal-say, 10 contracts a day. The excitement comes when the volume of options traded skyrockets-if, say, the company discovers oil, receives FDA approval for a new drug or is about to be acquired. Since the incremental cost to the exchanges of listing options is small, they are happy to list the options in anticipation of the trading volume that such occasional events trigger.

As smaller and younger companies find themselves with listed options, treasurers of companies like Liposome, Keane and Pre-Paid Legal Services are confronted with financial strategies that have historically been considered the purview of larger companies. Research is usually their first step to making the best of the situation. Keane's Vale learned that most studies find a 10 to 20 percent reduction in volatility in the underlying stock after options are listed and an average increase in market value of 3 percent. Historically, an options listing has increased the number of analysts covering a company. The Wall Street Journal mentions companies 25 percent more often after options are introduced, reports Professor Dan Galai of the Hebrew University of Jerusalem School of Business Administration.

Deep and liquid

The advantages of options are not heavily debated. Their "effect on volatility is almost unquestionable," says Professor Menachem Brenner of New York University's Stern School of Business. This is because the options market provides an alternative to trading in the underlying stock. To the extent that options add to total trading in the company's instruments, the stock has more liquidity and depth; a deeper, more liquid market is less volatile. "Much of the volatility [in the market] is pure noise. Options don't reduce the genuine risk the stock carries. The volatility you observe in the market includes fluctuations that are not caused by pure risk," Brenner explains.

Both Liposome's Bovereaux and Keane's Vale can see how their companies might be subject to noise-related volatility. As a biotech company, Liposome is subject to the market rumors about new drug approvals that can trigger options activity. And Keane has doubled in size twice in the last two years because of acquisitions. Keane's revenue may also benefit from what Vale calls "the year 2000 problem," which will require many companies to embark on major reprogramming efforts to make sure that computers can handle the date change. Acquisitions among other software providers can add further volatility to the company's stock by providing new valuations for software stocks, Vale says.

In the face of such noise, options give investors a way to protect their positions-to buy insurance on holdings so investors can be less concerned about bad news. Brenner points out that with so many new options listings, for some companies not having an option may become a competitive disadvantage. Investors may choose to buy stock in a company that has options because it offers them an opportunity to hedge their exposure during volatile periods. For example, in a given industry, the investor may feel safer investing in a stock that offers the option to hedge rather than buying into a company that does not have listed options.

Friendly overtures

After learning about the basic capital market impact, companies ought to become acquainted with their options specialists. Most public companies ignore options trading, reports Johnnie Johnson, whose New York-based consultancy advises public companies on investor relations issues. All public companies track their equity prices and volumes, and most have a relationship with the specialist who makes a market in their stock. Options specialists can offer the same kind of information as stock specialists, but often tap into different rumors and observe different investor strategies. This is because wealthy individuals investing for their own accounts play a more significant role in options markets, while prices of the underlying equities are more likely to reflect institutional and mutual fund investor sentiment. So by ignoring options markets, companies are losing valuable information, Johnson argues.

He is talking from experience. Johnson ran investor relations at Marathon Oil when Mobil attempted an unfriendly takeover in the 1980s. When Marathon attracted two white knight bidders, Marathon watched options market activity to gauge which one the market thought was most likely to win. Johnson says that options buyers were an accurate predictor of the ultimate outcome because they were surveying the shareholders who were going to vote on the tender offers.

And while most companies will never be involved in an unfriendly takeover, Johnson points out that if they are, that is not the time to scramble to build a new relationship with their options specialist. And market insight is not valuable only for assessing M&A probabilities. Companies that watch options market activity are likely to learn much that is valuable in forming an investor relations strategy, he says.

Market response

The first thing to do is track the price and volume of options on the company. Newspapers provide limited information; because each put and call option has four expiration dates, three strike prices, and a bid­offer spread, they usually report partial information for only the most actively traded issues. Computer-based services such as Reuters, Bloomberg, ADP, Quotron, and Telerate offer complete information.

Options activity signals market response to some event. If a company sees increased options interest and is gearing up for an announcement-it may be planning to release better-than-expected earnings, to spin off a marginally profitable subsidiary, or to announce FDA approval of a new product-management is likely to suspect that a rumor about one or another of these events is triggering the unusual activity. The specialist may be able to tell which rumor is more credible.

Options specialists are eager to receive very basic information from the companies they trade, and most of them are pleased if the companies approach them. Dennis Gaylin trades between eight and ten companies at one time with LETCO Specialists at the American Stock Exchange. Many of these companies rely on the FDA to approve new products. He communicates regularly with the investor relations staff at some of these companies to find out whether earnings will be released on time and the status of FDA paperwork. Gaylin finds that this information helps him anticipate changes in trading volume.

Keep an eye on the Underlying

Since options trading activity often diverges from that of the underlying stock, stock specialists only give part of the picture, Gaylin says. Other valuable market sentiment can be gleaned by analyzing the implied volatility in pricing and figuring out whether investors are interested in short- or long-term securities' positions, or puts or calls.

Comparing the difference in activity between the derivatives and the underlying equity can also provide important insight. Since most investors know that the Securities and Exchange Commission polices the options markets more carefully than other markets, trading on inside information is more likely to happen on the underlying stock, says Gary Gastineau, senior vice president of new product development at the American Stock Exchange. The options markets, however, do respond to rumors that are not based on inside information, he adds. But rumor-based trading is spotty. Gastineau concurs with the consensus of specialists who say they are often the last to hear rumors about the companies they trade.

Keane's Vale says he already has a relationship with one of his specialists. The same trader who makes a market in Keane's common is also the options specialist at the American Stock Exchange. And so far this exchange accounts for 90 percent of Keane's options volume. Vale also plans to develop a relationship with his specialist in Philadelphia.

Liposome's Bovereaux also has plans to become acquainted with his specialists, just in case. He says that in his three years as Liposome's treasurer he has never seen a situation where he felt he needed information from the options market. "Would we have learned more about our company if we had watched the options activity? That's an unanswerable question."

The New Options in Stock Buyback Programs

During the last two years over-the-counter warrants have generated millions in tax-free cash as part of corporate stock buyback programs. And taking advantage of this opportunity should become easier, once the Chicago Board Options Exchange (CBOE) begins to make a market in flex equity options as it is expected to in June. But even without listed options, hundreds of companies-including McDonald's, Intel, and WMX Corp. (the former Waste Management)-have sold put warrants in conjunction with stock repurchase programs.

The beauty of this strategy is that it can generally lower the cost of the repurchase program with very little additional risk. Consider the case of a company that announces a stock buyback of up to 3 million shares. The company's intention is to buy back stock so long as the share price, now $70, stays below $72. At the same time it also sells puts for $2 that allow the purchaser to sell a share of stock for $60. If the company sells 3 million puts, it has raised $6 million. If the price of the stock rises, the puts will expire worthless and the company will have an extra $6 million to defray the cost of its repurchase program.

If the price of the stock falls to $55, the owner of the put option can buy the stock in the market and sell it back to the company for $60, giving the investor a gain of $3 ($5 less the cost of the $2 warrant, ignoring the cost of capital). In this case, the company will have to pay more than the market price for the share, but since the company has already decided to pay anything up to $72, the $58 ($60 less the $2 received for the warrant) still looks like a relative bargain.

And Uncle Sam keeps his hands off the $6 million. For both accounting and tax purposes, it is treated as an equity transaction. On the same principle that proceeds of an initial public offering are not taxable, proceeds of the sale of puts by a company on its own stock are tax-free.

Companies have been using this strategy since 1992, when the SEC effectively approved it by issuing a no-action letter for puts that are sold in conjunction with stock repurchase programs. Before this letter it seemed possible that the strategy could violate regulations that prohibit public companies from using material non-public information to make trading profits on their own stock. The SEC's letter, for example, said that companies could sell options in conjunction with an authorized stock repurchase program so long as they do not violate the same trading restrictions that the SEC has set for stock repurchase programs. This means, for instance, that they cannot sell puts in the first or last hour of the trading day. Companies are also not permitted to buy back stock while they are in possession of material non-public information. Some legal advisers interpret this to mean that they cannot redeem puts.

Potential legal exposure

After the SEC issued its letter, most companies began to sell puts over-the-counter rather than using the exchanges, says David Hall, vice president of institutional marketing at the CBOE. They were concerned that the letter created potential legal exposure for those that used exchange-traded options. The exchanges could only settle American-style options, which are exercisable at any time during their lives. This freedom raises the risk that a company may be forced to redeem the puts when it possesses material non-public information. By contrast, a European-style put can only be exercised on the maturity date.

In fact, some observers feel that IBM, which decided to continue to use exchange-traded puts, became vulnerable to SEC action. After selling puts, the company decided to take $9 billion in restructuring charges. In order to comply with SEC restrictions, IBM needed to suspend its stock buyback program while the announcement was pending. But the company could do nothing about its outstanding puts. The owners could still exercise those and the company was vulnerable to charges that it was buying back stock-which it had to do if investors presented their puts-while in possession of material non-public information.

With a European-style warrant, in contrast, the warrant can only be exercised on the maturity date, thus limiting the risk. The exchanges originally did not offer European-style options because they trade at a discount to par and few of the individual investors who play a major role in the listed options market have the expertise to price them properly.

New options

As of this summer, companies will be able to use exchanges to sell European-style options. The exchanges, which began offering flex options on indices in 1993 and on debt instruments in 1994, will offer them on equities also. Instead of limiting investors to the standard menu of equity options prices and maturities, the exchanges will make a market in customized issues so long as they meet minimum size tests-25,000 options or 2.5 million shares. These customized issues can carry European-style maturities.

Flex contracts will also allow exchange-traded options to offer other benefits of OTC products. For example, privately placed puts also allow issuers to set maturities than are not available on the exchanges and to set their own strike prices if the range of listed prices does not meet their targets, notes Chris Innes, an equity derivatives salesman at Salomon Brothers.

Several times over the last two years, WMX has auctioned OTC puts in conjunction with a repurchase program for up to 25 million shares of common stock. To set pricing parameters, the company uses an internal model, although it verifies the internal model's results with the option pricing model included with its Bloomberg screen, reports Bruce Tobeckson, the company's vice president of finance. Typically, the company sets the exercise price at an eighth below the current market price with maturities between three and nine months.

What is aggressive about WMX's program, says the CBOE's Hall, is that the company sold puts on 31.6 million shares when its repurchase program was authorized at 25 million shares. A company can double-dip like this without facing the possibility of buying back more shares than authorized only if the puts expire unexercised before the repurchase program is completed. For example, if an investor did not exercise three-month puts on 15 million shares and WMX had only bought back 5 million shares of its original 25 million allocation, the company could sell puts on another 20 million and generate additional premium revenue.

In fact, Salomon's Innes says he always recommends selling fewer puts than the number of shares under the repurchase program. The puts ought to be an enhancement to the repurchase program, not a substitute for it. "Companies should view the put as a hedge against a rising stock price," he says. WMX's Tobeckson doesn't view this strategy as particularly aggressive. "We've never had more than 10 million shares under put warrant contracts at any time," he says.

Further limitations?

The SEC's no-action letter expressly caps the number of options that a company can sell at the number of shares authorized under the share repurchase program. The CBOE's Hall observes that the SEC's letter applies only to exchange-traded contracts and so doesn't cover WMX's over-the-counter transactions. But, in his view, the letter would not permit a corporate issuer to sell more puts through the exchanges than the number of shares authorized under the repurchase program, even if some of the puts had expired unused. This poses a further limitation for a company that, like WMX, would want to sell a large number of puts on the exchanges. In most cases, he says, the puts would be substantially lower than the number of shares authorized under share repurchase programs.

Tobeckson sees some potential advantages to using listed exchanges, but he is not doing handstands, largely because he feels the over-the-counter market provides competitive pricing. But another high-placed source points out that perhaps listed exchanges will promote standardized contracts, which will simplify documentation for issuers that sell warrants to several investors.

Given the limitations the exchanges face, greater accessibility of exchange-traded options is likely to have only a moderate impact on interest in coupling the sale of puts with share repurchase programs. But that interest is likely to remain high as long as a rising stock market means that few relatively few puts will ever be exercised.

Options and Volatility: A Quick History of the Academic Literature

The consensus among researchers is that volatility declines subsequent to options listing, according to a as yet unpublished paper by Dan Galai, a professor at the Hebrew University of Jerusalem School of Business Administration. The effect may be weaker now than in the past, but it is still significant. The major reason for this phenomenon is increased competition and liquidity in the market for the underlying security following initiation of options trading, which leads in turn to a reduction in the noise associated with trading. The decline in volatility is associated with an increase in the volume of trading, but is not correlated with the observed increase in stock prices. Researchers have been unable to find evidence of selection bias in listing options on stocks that are expected to show reduced volatility. The evidence does support, however, the claim that options trading attracts more analysts and more investors to focus on the stock, and therefore increases the efficiency of markets for these shares. The full academic references for these studies can be found at the end of this article.

In 1979 Trennepohl and Dukes estimated betas for optioned and non-optioned stocks for the periods 1970­1973 and 1973­1976, and found that the betas of stocks with listed options dropped more than the betas of non-optioned stocks. Because they were using beta as a measure of stock-return volatility, they concluded that option introduction decreases the return volatility of the underlying stock.

Ten years later, in 1989, Skinner used a variance ratio test to determine if stock return volatility changes after option introduction. He calculated that stock return volatility drops 1,020 percent after listed stock options are introduced. His sample contained 304 CBOE and Amex options listed during the period 1973­1986. Skinner found that 69 percent of the stocks in the sample experienced a decline in volatility.

In the same year Conrad examined the effects of options which were listed from 1974 to 1980 on stock returns and found that the variance of the average excess return (computed from a market model) declines subsequent to options listing. The variance estimator based on 200 days prior to options introduction was 2.29 percent; it declined to 1.75 percent in the 200 days following options listing. Some 83 out of 96 companies in the study experienced a decline in volatility.

In 1990 DeTemple and Jorion found a significant increase in the price of the underlying stock around the listing date of the option, on the order of 0.6 percent on the listing day and 2.9 percent in the two weeks surrounding the listing date (after adjusting by the pre-listing average returns). Options delisting had a negative price effect. They estimated the magnitude of the decline to be approximately 7 percent for a sample of 300 option listings during the period 1973­1986.

In 1991 Damordaran and Lim found a larger decrease in volatility following option listing than did previous studies. For a sample of 200 listings between 1973 and 1983, they reported a decline of 20 percent in volatility of both raw returns and excess returns. When they decomposed the variance of the stock's rate of return to three components, they found little evidence of a decline in intrinsic variance. Most of the decline in volatility was attributed to a decline in the "noise" term. They claim that this result can be attributed to a reduction of either the bid­ask spread or of the "noise" encountered in the information process.

References:

Conrad, J., 1989, "The price effect of option introduction," Journal of Finance, 44, 487-498.

Damordan, A. and J. Lim, 1991, "The effect of option listing on the underlying stocks' return processes," Journal of Banking and Finance, 15, 647-664.

DeTemple, J. and Ph. Jorion, 1990, "Option listing and stock returns," Journal of Banking and Finance, 14, 781-801.

Nabar, P. and S. Park, 1988, "Options trading and stock price volatility," working paper, Salomon Brothers Center, New York University.

Skinner, D., 1989, "Option markets and stock return volatility," Quarterly Journal of Economics, 75-89.

Trennepohl, G.L. and W.P. Dukes, "CBOE options and stock volatility," Review of Business and Economic Research, Spring 1979, 49-60.