Let's assume that you hold sustantial employee stock options.

Assume also that you realise that hedging with exchange traded options reduces risk, increases your net after tax income, and is the only efficient way to exit your ESOs.

Assume also that you may want to hedge by writing calls on correlated stock for reasons of flexibility and convenience.

Assume you are aware of a paper by Yu Wei of University of Utah of November 2004 and  papers from Don Chance of LSU where they illustrate that executives of major corporations unintentionally will tip off the public when they make insider trades based on material non-public information.

The executives make the tip off of expected bullishness when they stop selling stock they have accumulated from options grants together with when they grant themselves employee options in large batches.

Essentially what they do is receive ESO grants before they expect the stock to rise and after the stock has fallen. They also make premature exercises and sales when they expect stock to decline.

What do you do to make the maximum trade?

Answer:

Executives of all companies must report all exercising of options and trades of stock within two days of the exercise or trade date. They must also report all grants of ESOs.This is information is available through the S.E.C. or from private services (see www.secform4.com).

When considering writing calls on employer stock or stock postively correlated with the employer stock, first check to see what the executives have done with their in - the -money ESOs. If there are substantial premature exercises and sales of stock recently, you should act quickly to write LEAPs against your ESOs. This is the case because the probability is now greater than normal that the stock will go down after executives have exercised options prematurely and subsequently sold their stock.

The same idea applies as to the grants of options. When large ESOs are granted to the executives, avoid selling calls and maybe buy back some that were sold earlier.

For example on March 10, the CEO of Yahoo granted himself 2,900,000 options to buy Yahoo at the low closing price of the year and quit selling stock that he could get from exercising options. This was a tip off that news was coming and it did come 26 days later when the company declared great earnings and a 2/1 stock split. The stocK had risen from the 41.70 at the time of the 2,900,000 grant to above 55.

The Yahoo CEO granted himself 6 million options and about 5 million to other executives on May 31, 2006 to buy stock at 31,59 and they have sold only smaller amounts of stock.

The expectation is that the stock will rise. The only problem is that all eyes are on companies doing what it looks like Yahoo is set to do. The fix is in; the cards are dealt but, they just caught a lot of other cheats and maybe there will be news that will slam Yahoo stock prior to thier playing the hand.

 John Olagues

Hey Pete, How's the Reds look today?

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.