DELAY THE EXERCISE

It’s estimated that 14 million employees, executives and suppliers

in the US own stock options, granted as compensation in lieu of

cash. My estimate of the value of the options granted by the

employers ranges from $60- $70 billion per year on the

Standard and Poors 500 companies alone. (see Brian Hall 2003,

 "The Trouble with Stock Options" page 4) 

A whole industry has grown up around this arena of equity

 compensation. Employee options are by far the most

prominent part, although there has been an increase in

options substitutes.

There are expert tax lawyers, accountants, human resource

managers, benefits consultants, financial consultants,

appraisers, academics and stock brokers who dominate the

industry. As far as I can tell, there are very few experts in

the industry who have substantial experience in trading or

managing listed options portfolios. 

 Truth In Options was created to provide that missing

experience. We advise employees and executivess from

an experienced trader’s point of view on how to maximize

the after tax return on those employee held stock options.

OBJECTIVE:

Our objective is to get the most money after tax into the

hands of the employee/executive, with the smallest risk

along the way.

We do this by:

a) Preserving “time premium” in the options by avoiding

premature exercises.

b) Reducing delta and theta (erosion) risks by writing

listed LEAP call options.

c) Reducing risks associated with consentrated positions.

d) Minimizing and delaying negative tax consequences.

_____________________________________________________________

SPECIFIC ACTIONS:

This example applies mostly to non-qualified employee

stock options. Qualified Employee Stock Options

(Incentive Options) would be managed a bit differently.

We address Qualified Options later in this article.

This strategy assumes there is no prohibition by the

company from hedging the ESOs.

1. At the time of the grant, we annually sell (write) listed LEAP calls equal to 7% of the total grant with exercise prices similar to the ESOs. Over time, as expiration day approaches, we advise rolling back the short LEAP call position to later months. If you are assigned early the options you wrote, you can quite easily buy the stock and simultaneously sell new LEAP calls. Rolling back captures more time premium and lowers the risk of positve deltas from the ESOs. Rolling back also reduces the erosion risk.
2. Sell 7% more LEAP calls every year to expiration and repeat the process of rolling back. Try to liquidate positions showing losses and delay liquidating gains.
3. Sometimes, after large up - moves in the price of the stock or large drops in volatility and interest rates; there may be little or no “time premium” in the options. In this case, the incentive for avoiding a “premature exercise” is  smaller. In most cases, however, there are substantial penalties in the form of lost "time premium" and "early taxes" for "premature exercises".
4. Every year increase the number of listed LEAPS you are short until your total is approximately 65 -75% in the final years of your options.
5. Exercise your ESOs that are in the money weeks before expiration day and liquidate the remaining positions in a manner that minimizes taxes and risk.

This system is quite simple and I guarantee that, on average,

the after tax returns to the employee/executive will be 40-50%

higher than any exit strategy that advises systematic

“premature exercises”. This is true whether the stock is

sold in whole or part after exercise.

Here's where the extra 50% comes from:

Suppose a holder of ESOs has a choice of

a) exercising and selling  or 

b) hedging his ESOs with listed options and delaying the

 exercise to expiration day. 

Assume the ESOs give him the right to purchase 10,000

 shares at 20 with the current market price of the stock

at 30. Assume that two years have past from the date of the

 grant. Assume the volatility is 30 with no dividends. The

theoretical value of the options is $155,000 using an

expected life of 5.5 years.

If he exercises and sells he will receive $60,000 after

tax ($100,000 x .60).

If he invests the $60,000 and it doubles over the next

8 years, he will receive net $108,000 (i.e. $60,000 +

{80% x $60,000}) assuming the gain is long term capital gain.

On the other hand lets assume that he does not exercise early:

If the employer's stock doubles over the next eight years,

the stock will be trading at 60. This would make the

 unexercised ESOs to purchase 10,000 shares at 20 equal

$400,000 at expiration day. He will receive $240,000 after

 tax (i.e. $400,000 x 60%) upon exercise and sale.

$240,000 is greater than $108,000 by 120%.

If the employee systematically hedged the ESOs along

the way, his return would would be less than in the

above scenario. However, his expected return would not

have been much less. His risk would have been substantially less.

Why do we not find others advocating this hedging strategy?

Essentially, the answer is the employers don't want to see

hedging.

Few financial advisors understand listed options and are

afraid to get into something they know little about.

Financial advisors know taxes, whole life insurance,

annuities, mutual funds, and retirement plans. But they

do not know options.

Another reason that few promote “how to hedge employee

options with listed options” and in fact advocate “premature

exercises” is that “premature exercises” benefit the employer

at the expense of the employee. Who receives the

“time premium” that is forfeited? The company does.

And, the companies usually pay the costs of the designers,

 administrators and facilitators and advisors.

My estimate is that $10-12 billion will be lost by employees

and executives during the next 12 months and that

$10-12 billion will accrue to the companies.

Turning to the Qualified Options (Incentive Options),

our management strategy is slightly different. We recognize

 that if qualified options are exercised and the stock held

for over one year, the total gain from the later sale is

treated as long term capital gain rather than compensation

income as in non-qualified employee options. This difference

 may be as much as 20%.

Plus, any capital losses that the Qualified Option holder

 may have from other positions or from hedging his employee

options can be offset fully against the gain from the

Qualified Options.

We advise a program of selling 9-10% (rather than 7%) per

 year of the Qualified Options granted, beginning on grant

day and every year thereafter. We advise that the employee

 may have an incentive to exercise a bit earlier with

Qualified Options than with non-qualified options.

He should generally refrain from selling any of the stock

received from the exercise until over one year has passed.

 He can easily hedge with options or remain un-hedged

for that extra one year that he is required to hold the stock

to achieve long term gain.

Through out these periods of managing his options,

the employee must consider the probability he may

terminate his employment prior to the expiration of the

options and the effect his termination will have on the

expiration date. This consideration may influence the number

of listed options he uses to hedge.

Holding un-hedged ESOs has two major risks, a) the delta

 risk (which is the most significant) b) and the theta

(erosion) risk. If you are risk averse, you should reduce

the speculative risk of holding un-hedged ESOs.

John Olagues       olagues@hotmail.com

www.optionsforemployees.com

 

 

The author, JOHN OLAGUES, is a former member of the Chicago Board Options Exchange and the Pacific Stock Exchange for over ten years. He offers a unique view of employee stock options from a trader’s standpoint rather than from the standpoint of an accountant, compensation planner or academic. To contact JOHN OLAGUES email olagues@hotmail.com and  see www.optionsforemployees.com.