Preliminaries

 Some employees/executives desire to increase returns,

reduce risk, save "time premium" and defer taxes by selling

(writing) listed exchange traded stock options against their

 Employee Stock Options.

In some rare cases, employers may constrain hedging ESOs to

such an extent that the employee's hedging must be done

against a group of positively correlated listed stock options

rather than the listed stock options related to the employer stock. 

We believe, however, that selling listed options in either of

these manners is the most efficient way to manage Employee

 Stock Options. In addition, there are some surprisingly good

tax results to hedging ESOs, which we discuss later in this paper.

There are some financial advisers who advise against these

strategies.

They also claim that employer contractual constraints,

Section 16 b) and Section c) of the 1934 Act and SEC Rule 16 c) - 4

and Rule 10 b 5) and tax uncertainties make hedging with listed

options impractical.

Employer Contractual Constraints:

Certainly employees and employers can contract for whatever

terms they may agree on. The terms may prohibit all types

of hedging (against ESOs, restricted stock or even a basket

of related securities). This would be the exception rather than

the rule and is rarely acceptable to the executive/employee,

given the fact that these terms diminish the ESOs value. This 

type of restriction is one of the reasons why the executives

undervalue the options and argue for excessive grants. If the

employers actually facilitated efficient exit strategies, then the

options would be valued more and the company could grant

less options.

SEC Constraints:

Section 16 b) of the Securities Act of 1934 makes it such that

profits from trades in the equity securities of their companies by

officers and directors are recoverable if the profits are made from

trades within 6 months of each other.

This rule can be handled easily by initiating sales of long term

LEAP calls and avoiding purchasing profitable positions within

the 6 months.

If there are very large up moves in the short run requiring early

closing transactions, the only possible penalty is that gains

(which would always be "zero" in the case of large up moves)

would go to the company. So there is "no worry" about Section16 b).

SEC Rule 16 c-4 prohibits officers and directors from short sales

of stock options on company stock except to the extent that the

seller owns stock or equivalent stock positions.

In a Private no action ruling to Credit Swiss First Boston in

Mar 18, 2004,

www.sec.gov/divisions/corpfin/cf-noaction/csfb031804.htm

the SEC through Special Counsel, Anne M. Krauskopf gave 

approval to a holder of substantial in - the - money vested

 non forfeitable ESOs to make three additional trades. Those

trades consisted of 1) a sale of an out of the money call,

 2) a purchase of an out- of -the- money put and 3) a sale

of a substantially out - of - the - money put with the same

exercise price and time remaining as the in - the - money ESOs.

The four positions, in exchange lingo, consisted of long a foward

 conversion and a collar, having slightly positive deltas in total.

Looked at another way, the four positions consisted of long a

vertical call spread and long a vertical put spread. The long

vertical call spread (where the long ESO was in the money

and the short call was out of the money) gives long deltas.

The long vertical put spread (where the long put was out of

 the money but the short put was further out of the money) 

gives short deltas.

I personally asked  Anne Krauskopf the following:

If an executive mirrored those four positions and then eliminated

the long vertical put spread (which gave short deltas), would

the remaining long vertical call spread comply with SEC Rule 16c-4,

(as logic would require) because the remaining 2 positions were

more bullish under all circumstances than the 4 positions?

 Anne Krauskopf ageed that it would. So the SEC has agreed

essentially that the owner of substantially in the money vested

ESOs would be permitted to sell (write) out of the money listed

calls to the extent that the holder has either in the money

vested ESOs or stock.

So for officers and directors, the SEC will not object to selling

out of the money calls to hedge in - the - money ESOs as long

as the officer or director can never be in the position of having

a prospective gain if the stock drops.

SEC Rule 10 b 5) prohibitis buying and selling securities on material

non public information. Companies create "black out periods" for

the purpose of enforcing Rule 10 b 5).

Rule 10 b 5) must be complied with regardless of whom the hedger is.

It is just as easy to create Rule 10 b 5)-1 plans to hedge options

as it is to sell stock received from the exercise of the options.

So Rule 10 b 5) would produce no real difficulty.

Tax Uncertainty Constraints:

Some options observers claim that tax treatment uncertainties

constrain the use of listed calls to hedge ESOs.

They claim that in the event of substantial rises in the stock

after the initiation of the hedge, there will be substantial losses

in the shorted (written) listed calls. They claim that these losses

 are deductible only as capital losses or against ordinary income

to a maximum of $3000.00 per year. Whereas, the related gains 

from the employee stock options would be fully taxed as

 compensation income.

If the employee had $1,000,000 in liquidated ESOs gains and

$700,000 in listed options losses, he would net $600,000

($1,000,000- $400,000) after tax on the ESOs. He could deduct

the $700,000 against capital gains but only $3000 per year of

the $700,000 loss against ordinary income. Considered in isolation,

the net after tax result would be a $98,800 loss with a capital

loss carry foward of $697,000.

This possible result could be mitigated by selling less listed options,

perhaps 50% less. The capital loss would then perhaps be $350,000,

making it such that, under this scenario, considered in isolation, the

employee has a net gain before tax of $600,000

(i.e. $1,000,000 - $400,000) after taxes on the ESOs. The after

tax results would be a gain $251,200 together with a loss carry

foward of $347,000. Of course, selling less calls gives less

protection on the downside.

 Example:

 Lets look at a stock trading at $50 paying no dividend with

expected volatility of .30. The ESOs have an exercise price

of $30.00 and have an expected expiration date of 5 years

from today.

The theoretical value of those ESOs are $28.49 per option

assuming a 5.5 interest rate.

The theoretical value of two year listed calls with the same

assumptions for the underlying stock but with a strike price

of $55 would be $8.76 per option.

Assume that the executive owned 10,000 ESOs

(worth $284,500 theoretically) and decided to sell the 2 year

 listed calls as above on 5000 shares. He would receive approximately

 $43,800 from the sale.

If the executive held this position (called a long call diagonal in

trader lingo) till expiration of the 2 year listed calls, his results would be as below:

                       A                    B                      C                       D

Stock   Gain or loss on      T. V. of          Total A+B        C-Tax**

Price       Listed Calls       ESOs  After

                                           2 years*

30           $43,800            $89.650             $123,450       $108,250

40           $43,800           $171,600            $215,400       $197,628

50           $43,800           $262,400            $306,200       $288,428

60           $18,800           $357,700            $376,500      $369,000

70           -$31,200         $455,200            $423,000       $423,000     

80           -$81,200         $554,200            $471,000       $471,900

 

*   Assumes 3 1/2 expected years till expiration

** Assumes no loss carry forwards form other stock or

options positions

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Probability of stock being above 80 after 2 years when

starting at 50 = 17%.

Probability of above 100 = 7%.

Probability of above 150 is less than 1%

Probability of stock below 50 = about 42%

___________________________________________________________________________

If the hedger decided to sell 100 listed options

instead of 50 to hedge his 10,000 ESOs, the gains

and the losses from the sales of the listed calls would

be doubled.

Many detractors of hedging use a scenario of the stock 

advancing from 10 to 100, after hedging at 10 to

illustrate the negative tax results. However the

probability of a stock with a 30 volatility going

from 10 to 100 is very small and even under those

circumstances we would manage away most of the

 difficulty.

Tax Advantage

Here is an example of how an employee can get a

tax shelter from the proper management of ESOs

plus all the benifits of reduced risk, increased

earning and saved "time premium".

Assume an employee has just been granted NQESOs

 to purchase 100,000 shares of company stock

at $49.00 per share. Additionally, he was granted

 40,000 shares of restricted stock two years ago

which are now vested.

Let's suppose the employee "writes"  two year LEAP calls

 on 40,000 shares in 2006 with exercise price at 55 and

different two year LEAPs on another 40,000 shares in 2008,

after the stock has risen substantially and the ESOs are vested, 

with an exercise price of $65.00. He would receive two checks

 for the full value of the proceeds with no tax or borrowing.

 Perhaps the checks would be for $400,000 each and $500,000

 respectively. Any tax consequences on the "writes" will

depend on the gain or loss when the "writes" are closed or

the options expire.

The employee could use those checks to pay the tax on his

vested stock with no borrowing.

If the stock advances in the short run after both sales,

there would probably be a loss on one or both of the "writes".

If the employee purchases back some or all of the the losing 

"written" LEAPs and sells longer "qualified" LEAPs or those

 which have more appropriate exercise prices, the employee

would have a tax shelter equal to the loss on the liquidated LEAPs.

The taxes on the increased theoretical value in the ESOs and

the increased market value of the stock would be delayed to

 some time in the future. Pehaps as long as eight or nine years

 for ESOs and perhaps indefinitely for stock. The employee

may be able to hold the unliquidated theoretical gains in the

ESOs and the increased market value of the stock till the time

 he is retired and in a lower tax bracket.

If the stock decreases or stays the same, after the hedge, 

there would be an unliquidated gain on the "written" options.

The employee should just delay the taking of the gain as long

as possible. He may be able to find elsewhere an unliquidated

or liquidated capital loss to offset the gains from the "written"

options if he chooses to close the open 'write". 

When taking the gain or loss, he could just "roll back" to

higher priced options with appropriate strike prices and

receive more checks.

Executives must be concerned with SEC Rule 16 b) when

 liquidating gains.

IRS Straddle Rule 1092

Some claim that the starddle rule would eliminate the ability

to get the tax treatment in the above scenarios. That idea

is incorrect for two or more reasons.

There is an exception to the starddle rule when "qualified

covered calls" are written. And there is no such thing as a

"Fair Market Value" (as generally defined in law) of an ESO

and there is never an "unrecognized gain" because the ESOs

can not be sold or transferred.Therefore the effect of the

straddle rule is very small in the above scenario.

Even if the optionee was convinced that the Section 1092

Straddle Rule applied , it would be a bonus to the hedging

employee. If the straddle rule applied, he could select the

 "identified straddle" treatment making it such that any

losses incured and liquidated on the sale of the calls would

raise the cost basis of the ESO. This idea applies where

ever the sale of the calls or purchase of puts was made,

be it in his personal name or his IRA.

Constructive Sale Rule 1259

For all practcal purposes, the constructive sale rule will never

 apply, especially since we will rarely sell in the money calls.

We never advise doing collars or conversions that eliminate

all or most of the risk and potential gain. Selling substantially

out of the money calls and buying substantially puts is a

concession to theoretical in both cases. Collars do not r

educe theta risk.

John Olagues

P.S. For more on our method of using retirement plans or IRAs

to hedge  ESOs, call or email. Truth In Options is the only

 service to suggest this strategy.

Warning! The strategies in this article are not for everyone

and must be managed by experienced professional options traders. 

 

olagues@hotmail.com 

504-305-4449

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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.