Company Stock Options and Diversification

[F M All]

We are in the process of rebalancing for the first few years of ER and have some outstanding company stock options, vested, with a few years to run. Some are in the money, some are deep underwater.  How should we view these for diversification? Obviously they are equities, but what valuation should we use when considering stock/bond ratios? 

Should we use the current total value of the number of shares involved, as this is the equivalent exposure to  equities?  This would reflect the leverage of the options but may skew our portfolio as this is a significant number compared to our net worth, and is much greater than the profit if we exercise and sell.

Should we use the current realisable value of the shares? Pre or post taxes etc? This would reflect the value we could invest elsewhere, but understates the leverage of the options.

Should we split the shares into two groups by value - above/below par and treat each group differently?  In other words ignore the shares that are below par until they are worth something. If we took the total value of the above par shares this might be a mid course to reflect some of the leverage, but still overstates realisable $.

Thoughts?  How do you value company stock options in your portfolio?

 

[bongo2]

Strictly for allocation purposes your middle ground of using the number of shares of underlying stock for the options that are in the money sounds pretty good. If you are in the position where your out of the money options are so far out of the money that they're worthless, and your in the money options are so far in the money that they're equal to the stock (in volatility) then your approximation would be exact. The "real" way would be to compute the option delta for the each issue and multiply the number of shares by that delta. If the options are traded you can get the delta on Yahoo or Ivolaility or somewhere like that.

You may also want to penalize yourself in some way for your apparent concentration in a single stock.

For net worth, you would probably want to use the exercise value.