Lets suppose, in May 2003, you were granted Yahoo! ESOs

giving you the right to purchase 20,000 shares at $25.00.

The stock was later trading at $32 with expected time to

expiration of 5 years. You also had 10,000 shares that are fully

paid for.

You're worried the market is heading south and want to

reduce risk.

There have been no grants for the past six months

and you do not expect another for another a 9 months.

Here's what you should do.

If you want to reduce 55-65% of the risk, sell (write) 300

LEAP calls on company stock with a strike price of $35.00. 

One hundred of the calls will be considered covered by the

10,000 shares and two hundred will be considered "naked"

by your broker, normally requiring margin. But if you deposit

the fully paid for shares of stock, the margin requirement is

eliminated on the covered and the  "naked" writes, even

when no consideration is given to the fact that you hold

the 20,000 ESOs. Most brokerage firms require excessive

margin for 'writing' naked calls. But there are some

fine ones who do not  See:

www.cboe.com/micro/margin/strategy.aspx

Let's look at market prices of the January 2008 LEAP calls,

with an implied volatility of 31 in May 2006.

On May 1, 2006, with the stock at 32, the Jan 2008 calls,

with a 35 strike price were selling for $515 per LEAP to buy

100 shares. If you sold three hundred at $515 you would

receive $154,500 which would be credited to your

account immediately.

You can take most of the $154,500 out to spend or

reduce your credit card balances or buy CD's.

You can take the money out, without tax or borrowing. No

interest charges will be applied. If your broker will not allow

what I am suggesting, you should find another broker.

I'll help you find one.

Before the sale (write) of the 300 LEAP calls, your deltas

(or equivalent stock positions) were long 27,000

(i.e. 10,000 shares + [20,000 ESOs with a delta of .85 each]).

After the sales, your total deltas became (27,000 long -

[30,000 x .57 deltas]) = long 10,000 deltas.

**********************************************************

Pre-hedge Stock Equivalents      Post-hedge Stock Equivalents

10,000 shares =     + 10,000         10,000 shares =    + 10,000

20,000 options =    + 17,000         20,000 options =   + 17,000

                                        short 300 listed calls =    - 17,000 

____________________________________________________________ 

Total             =     + 27,000              Total         =     + 10,000

***********************************************************

So you have reduced your risk by 61%, and still maintain a

long delta position. You will receive the proceeds of the 300

LEAPS immediately. Essentially, you sold some of your

employee options' valued at market prices. You owe no tax

and forfeited no "time premium" back to the company.

The above scenario was modeled on Yahoo!. 

Under the above scenario you are still long the equivalent

of 10,000 shares of stock immediately after the write of

the 300 listed calls

The net value of the sum of all positions will increase if the

stock advances. There is the possibility of a margin call

if the stock moves substantially higher in the short run.

You can decrease the risk of a margin call by selling fewer

LEAPs, perhaps 250 instead of 300. Although, you would

have less protection on the downside.

If the stock goes to 39 and there is a margin call, there is

nothing to worry about. All you have to do is make an

adjustment in your account. For example: you can cover 100 of

the 35 calls and sell 70 of the 45 calls and sell 1500 shares

of stock. You could also return some of the $154,000 or

exercise a very small number of the ESOs and deposit that

stock into the account. Executives have to be careful of

buys and sells within 6 months of grant day. 

 

Taxes:

It is my view, that the gains or losses on the sales of the

options will be treated for tax purposes the following way:

1) The gain or loss on the 100 covered calls should be

treated as short term capital gain or loss because the sale

of one hundred of the calls would be considered "qualified

covered calls" and are not subject to the Straddle Rule

Section 1092 nor the IRS Section 1221.

2) The gain or loss on the 200 "naked" calls may

be ordinary income or losses if you designate the offsetting

trades as "hedging transactions" under Section 1221.

However if you choose not to designate the

gains or losses as ordinary at the time of the trade,

a argument can be made that the gains or losses are

short term capital gains and losses.

If you have other stock positions in other companies, you

may have some with un-liquidated capital losses, which can

be "harvested" to totally offset any gains that you may achieve

on the sale of the options, assuming the gains are considered

capital.

So its quite possible that you can receive indirectly most of

the full "Fair Value" of the ESOs without having to pay

any tax on the gain.

Update:

Yahoo was trading at 33 with the LEAP calls with a 35 strike

trading at 5.30 - 5.40. We have had a slight bit of erosion in

our favor with the written LEAP calls.

However, Yahoo has granted over 10 million executive

stock options to executives on May 31, 2006. There has

been little selling of stock or premature exercising of options

over the past few months by executives.

It may be the case that the earnings will surprise for Yahoo

on July 18, 2006 and that is why all the ESOs have been

granted on May 31,2006.

After the earnings announcement, we recommend hedging

as much as you wish by sales of listed calls.

Watch out if that news comes prior to earnings.

Yahoo Update

On July 19, Yahoo dropped over six points to around 26. The Jan

2008, (35) calls were trading at $ 2.30-35.

What should the hedger do at this time? He could sell part

of his stock or sell more calls or do nothing.

My advice is to sell a few more calls (25) with strike

price of 30 using the Jan 2009 LEAPs, or sell some shares

of stock (if some of your Yahoo stock would give a

capital tax loss).

Either choice would reduce the long deltas.  If you are an officer

or director, you would not want to buy the written calls back

under any circumstance or for that matter any other calls

or stock. Section 16 b of the Securities Act of 1934 would

require that the gains are returnable to the company. You must

wait untill six months after you made the sale to liquidateda gain.

Yahoo! Update

On November 8, 2006, Yahoo! stock is trading at 27 with the

January 2008 (35) trading at $1.70 -1.80.

Writers of the Jan 2008 (35) would have an unliquidated profit

of $3.35 on each call sold. Buying those calls back causes a

taxable event, which you should avoid unless there are liquidated

or un-liquidated capital losses to offset those gains.

The executive now has substantially longer total deltas than

when he did the initial sales (writes). This is due to the reduced

value of the Jan 2008 (35) calls that he wrote.

Buying back 300 of those Jan 2008 (35) calls at $1.75 and

selling 190 of the Jan 2009 (30) calls at 5.30 will reduce

the delta and gamma risk and still preserve the positive erosion

of the hedge. You will also receive another check without

tax or borrowing of $48,000.

Instead of selling the full 190 Jan 2009 (30) calls, you could

sell 120 calls and 4000 shares of stock if the stock gives a

capital loss tax deduction. This will get an even larger new check.

If you are a 16b executive and make the sales of Jan 2009

calls or stock, you may consider doing so out side of

6 months from the grant days.

 

John Olagues

olagues@hotmail.com

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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.