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Shows How hedging ESOs is superior to diversifying. There are substantial costs to true diversification of assets in commissions, management fees, and accounting fees http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html
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John OlaguesTruth In Options504-305-4449 www.optionsforemployees.com/articles [email protected] John OlaguesTruth In Options www.optionsforemployees.com
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Managing your Employee Stock Options
This presentation is a comparison of two strategies for managing your employee stock options. The first is holding the ESOs to expiration un-hedged. The second strategy is to efficiently hedge the positions by selling exchange traded calls.
We will begin by making some assumptions. 1. A grantee holds vested employee stock options to buy 3000 shares of Google at $350 per share with 20 months to expiration. We also examine the case where he owns ESOs to buy 3000 shares for $350 with 44 months to expiration. 2. Google is trading at $416.
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3. The grantee is considering selling 30 Google exchange traded calls with 20 months to expiration exercisable at $450 per share which he expects to hold short until the calls expire. 4. The calls are trading at $8300 each.
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The horizontal axis of the graph below indicates the stock prices of Google stock at expiration of the calls sold (i.e. 20 months). The vertical axis measures the total value that is received with each of the three different scenarios.
The blue graph show the results if the 3000 employee stock options are held to expiration without any hedging or premature exercises.If the stock is trading at or below $350 at expiration, the grantee's ESOs will be worthless. If the stock is trading at $750 at expiration, the ESOs would be worth $400 X 3000 or $1.2 million.
If the stock is trading at $600 at expiration, the expiring ESOs with an exercise price of $350 are worth $250 for every ESO or (3000 x $250 = $750,000 in total for the 3000 ESOs).
With the stock at $600 on expiration day, the value of the calls sold at $8300 each would be trading at $15,000 causing a loss of $6700 per option sold.The loss on the calls sold reduces the total value of the positions by $6700 per call sold ( i.e $201,000 for the 30 calls sold).
The Green Graph shows the results of hedging the ESOs (with 20 months to expiration) by selling 30 calls with the same expiration.For example: Assume that Google closes at $550 at expiration, making the value of each ESO equal $200 or $600,000 for the 3000 ESOs. The calls would be worth $10,000 each, giving a $1700 loss on each call or $51,000 for the 30 calls.
The Red graph shows the results of selling 30 of the same calls at $8300 each. However, the expiration of the second 3000 ESOs is 24 months after the calls that were sold would expire.The difference between the green graph totals and the red graph totals equals the "time value" still remaining in the ESOs which have 24 months to expiration.
The Red and Green graphs show sales ofcalls on the shares of Google equal to the number of the ESOs held. We seldom recommend a full one to one hedge and restrict the sales of calls to be 60% - 70% of the ESOs held. Essentially, because of tax, margin and alignment issues we prefer to always keep our deltas (i.e. equivalent stock position) substantially positive.
In Conclusion:The comparison illustrates that hedging reduces risk and reduces the potential gain. In my view, hedging is a far better choice to reduce risk compared with the strategy of premature exercises and sales which forfeits the remaining time premium and incurs an early tax.