In Finance, options are used to mitigate risk and secure the possibility to capitalize on future inefficiencies in the market. The basic “call” option, in a nutshell, works in the following way: the buyer pays a relatively small premium to the owner of the stock for a clearly defined period of time in order to purchase not the stock itself, but the option to buy the stock further down the line for a set reference price that is agreed to by both parties.
Options create more opportunity for gains because, since current market valuations are likely to be more accurate and ubiquitous than hypothetical futures, options give the buyer the chance to cash in should market shifts cause the underlying asset to be valued higher than the reference (or strike) price. When stocks are believed to be undervalued, buying an option on the stock, although pricier if exercised than the actual current value of the stock, protects the buyer against the possibility that the stock never becomes valued higher than the strike price. Generally, the premium is low enough for the buyer to easily absorb should the asset not rise sufficiently. This methodology is particularly lucrative if the stock in question is subject to volatility, such as (1) stocks that have dropped temporarily due to market swings or PR scandals or (2) stocks that are either start-ups or valued prior to the cusp of some boom in the market.
We see options for the first type of volatile assets utilized successfully in MLB contracts quite frequently. This is the type of contract doled out to free agents coming off of “down” or injury-plagued seasons. Usually, a team will agree to a short term, low base contract with the player while including a second year “option.” The option, if exercised, generally costs more than the short-term contract. But, ideally, the price would still be lower than the market value of the player should he rebound in health or productivity. If the player breaks out under team control, the team reserves the right to exercise the option at a relative discount to the market. If the player does not recover, the team may decline the option (usually for a small buyout). This is an excellent low-risk/high reward strategy.
Options for the second type of volatile players are much more rare. Occasionally, when a player extends with a team or signs a long-term free agent contract, the team will slap an option year or two at the end of the deal. This is all well and good, but it doesn’t really protect the organization against the risk of attrition, bust, or even stagnation, because there are still quite a few years of guaranteed money built into the contract.
The perfect candidates for pre-boom options are players in their initial cost-controlled years who possess high ceilings but have not yet broken out. These players, like all players still dreaming of the big pay-day once their indentured servitude in the closed MLB market expires, seek stability and lucrative pay. Teams hope to lock their future stars down before they get expensive. The only roadblock to pleasing both parties is risk. The organization asks, “what if we commit millions to young Danny Baseball and he never turns into a star?” Danny Baseball asks, “what if I sign too early, for too little, and become a star?”
I believe that stock options, call options in the truest sense, provide the solution to this quandary.
Let’s consider the situation of Adam Jones and the Baltimore Orioles. Adam Jones is a 5-tool talent, a former top prospect acquired from the Seattle Mariners in the epic five-for-one Erik Bedard trade in 2007. Jones has turned himself into a productive starting center fielder, although, to this point, poor plate discipline, inconsistency and some defensive questions have prevented him from taking the next step into star territory. Jones is young, athletic, and charismatic, all the things you look for when committing to a franchise face. But the uncertainty over whether he will make that next leap has prevented the sides from seriously discussing a long-term deal at this point. Baltimore, it seems, would like to wait until they consider Jones more of a sure thing.
I consider this an inefficient strategy.
With every ticking season, Jones creeps closer to free agency, and his incentive to sign an extension rather than wait to test the market fades. Should Jones have a breakout season in 2011, his contract demands will rightfully sky-rocket. Understandably, Baltimore’s front-office is averse to the risk of guaranteeing Jones tens of millions of dollars only to see him stagnate, regress, or get bogged down with injuries.
The solution? Stock options, of course!
Let’s engage in a hypothetical. Imagine that the Orioles’ camp has assessed Jones’ value-at-risk and decided that they are comfortable offering Jones a 5 year deal, buying out Jones’ three remaining arbitration years and two free agent seasons, structured in the following way:
2011: $3 MM
2012: $6 MM
2013: $9 MM
2014 (FA): $10 MM
2015 (FA): $10 MM
Remember, the first three seasons are arbitrated and cost-controlled, so their value is suppressed. Almost all extensions are structured in this way. This deal would amount to a total of 5 years, $38 MM. If Jones stagnated as a ~2 WAR player, those two FA years will have been purchased right at market value.
Jones, however, doesn’t have much incentive to take this deal. A solid or better season in 2011 would cause a boom in his expectations. Let’s say, for the purposes of this hypothetical, that Jones’ camp countered with the following demands:
2011: $3 MM
2012: $6 MM
2013: $9 MM
2014: $12 MM
2015: $13 MM
2016: $15 MM
For a total value of 6 years, $58 MM. Jones’ version gives him an added year of security and 20 million dollars more in guaranteed money. Assuming that this discrepancy is too large to bridge, I propose this counter offer from Baltimore’s camp:
2011: $4 MM
2012: $7 MM
2013: $10 MM
With an option to buy at the following reference price:
2014: $11 MM
2015: $12 MM
2016: $14 MM
Take a look at what that deal does for both sides. If Baltimore exercises the option at the strike price, Jones gets his six year, $58 MM deal to the dollar. It’s simply structured a bit differently. Should the Orioles decline to purchase the option, Jones will have received $3 MM (plus a small buy-out reward) more during his arbitration years than he likely would have otherwise, and he gets to hit free agency like he wanted to all along. Should Jones break out, Baltimore would likely exercise the option and get three more years of production at below-market rates. Even if Jones fails to develop, the Orioles will have simply wasted one million dollars per season for three seasons. Yes, one million dollars is a lot of money, but in the realm of MLB it is hardly cost-prohibitive or hampering in any real way. It’s the price of acquiring Cesar Izturis to sit on the bench.
And now for my caveat: I am in no way privy to front office discussions or the asking and offering prices of either camp. These numbers are entirely made up, though they seem fair by my valuation. In any case, the details don’t matter so much. What is important here is the methodology. Players earn so little in their cost-controlled seasons that even a premium that is relatively insignificant in terms of an ML organization’s payroll can represent a 25% or more increase in pay. If, as some have theorized, Scott Boras and other agents might be successful at convincing their clients to hold out for free agency by offering them monetized insurance, this is the organization’s rebuttal. I imagine it would be very difficult to turn down a contract that offered both additional money up front and the opportunity for a lucrative long-term deal as well. From an organization’s standpoint, the contract might have some small incentive effect to push the player to stay productive before the option expires.
There are plenty of other ways to structure option-based extensions, like paying a higher yearly premium for the right to go year to year with increasing options. However they be utilized, contract options provide an avenue for small- and mid-market teams to exploit inefficiencies in the market in order to retain their talent. The more limited the resources, the more creativity is necessary in the negotiations. Smaller market teams just can’t afford to have big money contracts go bad. It’s not that these teams should be averse to the risk of locking up talent, they should just be finding creative ways to mitigate that risk.
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