How Professional Market Makers Would Manage Employee Options

By

John Olagues and Ray Wollney

There is an increasing interest among holders of employee stock options and their advisors in how best to manage employee stock options, especially those that are substantially in-the-money (n1) .

In the past, executives and employees alike thought that the way to manage options was to hold them until the stock doubled or tripled. Then and sell the stock. Pay the tax and buy a new home and some mutual funds.

There were economists, mathematicians and professional market makers who advised holding the options to , thereby extracting the most from the options.(n2)

However, few owners of ESOs are mathematicians or economists or professional market makers.

Today, things have changed. do not go up like they did in the late 90’s and companies must report the “Fair Value” of ESO grants as a hit against earnings (albeit over the vesting period) (n3).

We also have the phenomena of Google transferable options entering the mix. Is this the new paradigm of ESOs where the grantees become conscious of concepts like “time premium”, “intrinsic value “, “delta”, “implied volatilities” and “lognormal stock price distributions”.

In general, advisors tell grantees that the only way to manage the options is to systematically exercise the ESOs after the stock goes up, sell the stock and diversify.(n4) 1 Unlike listed calls, ESOs are not traded or transferable. Their value is strictly theoretical made up of “time premium” and “intrinsic value( which at grant is zero)”.

In most cases when an ESO is granted, the exercise price equals the stock price on the grant day. Therefore, in most cases, all of the value of the ESO at grant is “time premium”. The ESO will only be exercised when and if the stock is above the exercise price. In most cases the options have been granted with 10 years of life.

In the case of high stocks, this time premium can be quite high. As an example of how high that premium can be, we focus on Google stock trading at 470. Using a .30 volatility, the 10 year ESO (with 6.3 year expected life) just granted would have a time premium of $187.00. Using a .40 volatility, the ESO would have a theoretical time premium of $213.00 per share.

That theoretical time premium can not be sold by the employee. He must generally wait for the stock to rise and then exercise the options and sell the stock to receive a profit.

If the stock rises to 600 with 5 years to expiration (expected time to expiration of 4 years), the total theoretical value with an assumed volatility of .30 would be $252 (i.e.

$130 of intrinsic value plus $122 time premium). If the employee exercised the ESO he would forfeit the $122 in remaining time premium back to the company.

It is the purpose of this paper to explain how to avoid the forfeiture and then capture that time premium or more. We recommend the “writing” of term slightly out-of-the-money calls against the in-the-money ESOs as the preferred method.

The results using those techniques will be superior to the results of premature exercise, sale and diversify strategies. In our view, the expected advantage is 40-50% after tax over

2 the life of the options with less risk, compared with the premature exercise and sell strategy. The proof of this is, however, beyond the scope of this paper.

Employees and executives have a choice of three strategies:

1. Hold the ESOs to expiration “naked”.

2. Make what are thought to be strategic premature exercises and sales of stock, followed by diversifying the net after tax proceeds.*

3. Strategically hedge a portion of the ESOs and stock issued by the employer by “writing” listed long term out-of-the-money call options.

* Transferable Options give employees a Fourth choice but we do not focus on these as we consider these to be an improved hybrid of Strategy 2.

Strategy 1 offers the most potential gain and the greatest risk. Strategy 1 also offers the least amount of management and accounting costs and attention. However, “naked” options are by their nature high risk speculative instruments. Holding “naked” options, whether listed or ESOs is not for the risk averse. The stock may go down. And the “time premium” may erode even if the stock stays the same or increases moderately.

If the employee/executive fully understands the risks of holding un-hedged ESOs, his decision to hold un-hedged options to expiration may be his wisest choice. Only time will tell.

But it must be remembered that there is a substantial probability that the options will be worthless at expiration day, especially if the stock is highly volatile.

3 Illustration of Risk of Holding Stock Options to Expiration

The matrix below gives an idea of the risks associated with holding un-hedged ESOs if you believe in the accuracy of theoretical options pricing models. These models make the assumption that stock prices are log-normally distributed.

Expected time to Expected Volatilities Probabilities of ESOs Expiration of the Underlying Stock being Worthless at Expiration

7 yrs. 50 30 20 15 .62 .41 .26 .15

5 yrs. 50 30 20 15 .60 .40 .29 .20

3 yrs. 50 30 20 15 .57 .44 .35 .25

1 yr. 50 30 20 15 .54 .47 .40 .35

The ESOs with 5 years of expected time to expiration and an assumed expected

volatility of .30 have a 40% probability of being worthless at expiration. (n5)

As can be seen, the higher volatility stocks have a greater probability of being

out-of-the-money at expiration. All calculations are made when the stock is

trading at the same price as the exercise price. The expected rate of return is 8%

4 Strategy 2 consists of waiting for the stock to rise and then making premature exercises

(when the underlying stock is perhaps 75% to 100% higher than the exercise price) and then selling all or part of the stock. Part of the proceeds from the sale of the stock is used to pay the exercise price and any taxes that become due. The employee/executive then invests the net after tax proceeds in a diversified portfolio.

The graphs below illustrate the results of premature exercises. As can easily be seen, the after tax results of this strategy are less than 50% of the “Fair Value” (i.e. theoretical value) of the ESOs when the stock is 100% above the exercise price.

5 Employee Stock Options Management

Black Scholes Theoretical Values (1,000 Options)

Stock Price

2.3 years $60 Theoretical Value = $42,670 expected time remaining

3.3 years $50 Theoretical Value = $34,740 expected time remaining

4.3 years $40 Theoretical Value = $26,460 expected time remaining

5.3 years $30 Theoretical Value = $19,300 expected time remaining

6.3 years $20 Theoretical Value = $11,490 expected time remaining

5.3 years $10 expected time remaining Assumptions : Theoretical Value =$3,819 • Exercise price = $20 • Stock = $20 at grant day • Assumed volatility = .60 • assumed = 3.00% • Expected time to expiration = 6.3 years at grant date • Dividend = 0

Employee Stock Options Management

Black Scholes Theoretical Values (1,000 Options)

Stock Price

2.5 years $60 Theoretical Value = $42,373 expected time remaining

3.5 years $50 Theoretical Value = $33,368 expected time remaining

4.5 years $40 Theoretical Value = $24,526 expected time remaining

5.5 years $30 Theoretical Value = $16,114 expected time remaining

6.5 years $20 Theo. Val. = $8,290 expected time remaining

5.5 years $10 expected time remaining Assumptions : Theo. Val. =$1,427 • Exercise price = $20 • Stock = $20 at grant day • Assumed volatility = .30 • Interest rate assumed = 5.00% • Expected time to expiration = 6.5 years at grant date • Dividend = 0

6 Employee Stock Options Management (cont’d.)

Theoretical Value Components (1,000 Options) Theoretical Value = Time Premium + Intrinsic Value (Amount forfeited upon (Stock price less exercise of ) exercise price) Stock Price

2.3 years $60 $2,670 $40,000 expected time remaining

3.3 years $50 $4,740 $30,000 expected time remaining

4.3 years $40 $6,460 $20,000 expected time remaining

5.3 years $30 $9,300 $10,000 expected time remaining

6.3 years $20 $11,490 expected time remaining 5.3 years Assumptions : $10 $3,819 expected time remaining • Exercise price = $20 • Stock = $20 at grant day • Assumed volatility = .60 • Interest rate assumed = 3.00% • Expected time to expiration = 6.3 years at grant date • Dividend = 0

Employee Stock Options Management (cont’d.)

Theoretical Value Components (1,000 Options) Theoretical Value = Time Premium + Intrinsic Value (Amount forfeited upon (Stock price less exercise of option) exercise price) Stock Price

2.5 years $60 $2,372 $40,000 expected time remaining

3.5 years $50 $3,368 $30,000 expected time remaining

4.5 years $40 $4,524 $20,000 expected time remaining

5.5 years $30 $6,114 $10,000 expected time remaining

6.5 years $20 $8,290 expected time remaining 5.5 years Assumptions : $10 $1,427 expected time remaining • Exercise price = $20 • Stock = $20 at grant day • Assumed volatility = .30 • Interest rate assumed = 5.00% • Expected time to expiration = 6.5 years at grant date • Dividend = 0

6 Employee Stock Options Management (cont’d.)

Exercise and Sale Impact (1,000 Options) Time Premium Tax Net Proceeds Upon Exercise and Sale (Amount forfeited upon (Due upon exercise) (Intrinsic Value less Tax) exercise of option) Stock Price

2.3 years $60 $2,670 $16,000 $24,000 expected time remaining

3.3 years $50 $4,740 $12,000 $18,000 expected time remaining

4.3 years $40 $6,460 $8,000 $12,000 expected time remaining

5.3 years $30 $9,300 $4,000 $6,000 expected time remaining

6.3 years $20 $11,490 expected time remaining Assumptions : 5.3 years $10 $3,819 expected time • Exercise price = $20 remaining • Stock = $20 at grant day • Assumed volatility = .60 • Interest rate assumed = 3.00% • Expected time to expiration = 6.3 years at grant date • Dividend = 0

Employee Stock Options Management (cont’d.)

Exercise and Sale Impact (1,000 Options) Time Premium Tax Net Proceeds Upon Exercise and Sale (Amount forfeited upon (Due upon exercise) (Intrinsic Value less Tax) exercise of option) Stock Price

2.5 years $60 $2,372 $16,000 $24,000 expected time remaining

3.5 years $50 $3,368 $12,000 $18,000 expected time remaining

4.5 years $40 $4,526 $8,000 $12,000 expected time remaining

5.5 years $30 $6,114 $4,000 $6,000 expected time remaining

6.5 years $20 $8,290 expected time remaining Assumptions : 5.5 years $1,427 $10 expected time • Exercise price = $20 remaining • Stock = $20 at grant day • Assumed volatility = .30 • Interest rate assumed = 5.00% • Expected time to expiration = 6.5 years at grant date • Dividend = 0

7 Of course, if time is running out and the volatility is very low or there is a pending

substantial dividend, these may be reasons enough to justify the premature exercise.

Strategy 3 consists of systematically “writing” exchange traded out-of-the-money

long term calls versus the ESOs and company stock that the employee may own.

This strategy recognizes that there is an advantage to avoiding the forfeiture of remaining “time premium” and an advantage to delaying taxes, both of which are accomplished by writing slightly out-of-the-money long term calls.

Which listed calls are the best to write and when?

The answer depends on a number of factors. Executives who are subject to

Section 16 b of the 1934 Act (n6) have concerns that other managers do not. So the exact strategies are somewhat different. Generally we advise writing long term slightly out-of- the-money calls for all holders of ESOs.

Lets take an example:

Assume a Section 16 executive owned 100,000 shares of Yahoo!. In May 2002, he was also granted the right to purchase 200,000 shares with an exercise price of 25.

On May 1, 2006, the stock closed at 32 and the ESOs had five years of “expected”

time to expiration.

The total “deltas” of the positions were 270,000 long. (i.e.100,000 from the stock plus

170,000 from the ESOs).

Assume that the executive writes 3000 calls in the open market with an exercise price of 35, expiring in Jan. 2008. Assume that he received $515 per option contract.

8 The proceeds would have been $1,545,000 before commissions.

If the shares were fully paid for, the executive could have merely placed the shares in

his brokerage account. The 100,000 shares would have been sufficient to cover any

requirement as a result of the sale of the 3000 calls, and allow most of the

proceeds to be returned to the writer immediately with no taxes or borrowing.(n7).{If

he owned no company stock, he would have had to advance margin in the form of

cash or securities to execute and hold the positions.} The total negative “deltas” from

the sale of the 3000 calls would have been approximately -170,000. The total

summed net deltas of all three positions after the write would have been:

+ 100,000. = (+ 100,000 shares + [200,000 x .85] – [300,000 x .57]).

On September 1, 2006, Yahoo! stock was trading at 29.5 down 2.5 points from the

May1, 2006 price of 32. The Jan 2008, 35 calls were trading at 3.10 down 2.05. The

ESOs exercisable at 25 would have been down perhaps 2.25 in “Fair Value”.

The gains and losses would be as follows:

a) There would be an un-liquidated gain of $615,000 on the calls sold b) There would be a decrease in theoretical value of the ESOs by about $450,000 c) There would be an un-liquidated loss of $250,000 on the stock held

Therefore, the value of the combined positions would have decreased by $85,000, although the combined positions had deltas of +100,000 before the drop of 2.5 points.

The gain on the calls sold almost eliminated the losses on the stock and ESOs combined.

Why would this be the case when the deltas on the written calls were only - 170,000?

The explanation is that the written calls decreased as a result of erosion and a reduction in not just because of the negative deltas.

Had the stock advanced 2.5 points rather than decreased 2.5 points, there would probably 9 be a net gain on all positions of about $500,000 to $550,000 due to the net positive deltas of the whole position, the erosion of the time premium and the decrease in implied

volatility (n8). There would have also been some interest made on proceeds of the write.

On February 2, 2007, with Yahoo! at $28.77, the Jan 2008, 35 calls are trading at

$1.85 (down $3.30) with the stock down $3.23 and the ESOs down about $2.80 in theoretical value. The net 100,000 long delta position would have a profit of over

$107,000 with the stock being down $3.23:

Gain on write of 3000 Jan 2008 35’s = $ 990,000 Loss on Long 100,000 shares = $ 323,000 Loss of Theoretical Value of ESOs = $ 560,000 ______

Net Gain = $107,000

There would also have been some interest earned on the proceeds of the sale of calls.

Taxes

Lets examine the possible tax consequences of writing the 3000 calls at $515 and receiving a total of $1,545,000.

There are no tax consequences from the sale or receipt of the proceeds. Taxes may be due upon the closing of the position or the calls expiring unexercised.(n9) .

If he did close the written calls, in order to stay hedged, he should “roll forward” the original “write” by selling the Jan 2009, 35 calls and receive another deposit to his account equal to the one year time spread on the calls.

The executive may have had other liquidated or un-liquidated capital losses to use against the gains from the closing of the profitable “written “calls . If he had none, he should delay closing the written calls. 10 If the stock had advanced from 32 to 40 from May 1, 2006 to February 2, 2007 instead of decreasing as it did, there would be a loss on the Jan 2008, 35 calls, perhaps equal to 3 points. The executive could then buy back those written calls and sell the Jan.

2009, 40 or 45 calls and report a term capital loss of $900,000. This liquidated loss may offset other liquidated capital gains, perhaps from gains on the “writing” of other listed options. (There are some who claim that Section 1092 Straddle Rule would prohibit the taking of a current capital loss under these circumstances.)

By strategically “rolling forward” the written losing calls and holding profitable positions (for example the 100,000 shares would be up 8 points, giving an $800,000 profit and the 200,000 ESOs would be up perhaps 6 points, giving a theoretical profit of $1,200,000), the executive can delay his taxes on the ESOs for as long as 8-9 years or

in the case of the stock indefinitely.

If the stock is below the ESOs’ exercise price at expiration, the ESOs would be worthless and no ordinary income tax would apply. But, he would have made several large gains on the written calls. If he had other liquidated capital losses to offset gains, he could use those loses to offset the gains from writing the listed calls..

Section 1092 Straddle Rule

Arguments can be made on both sides of the issue of whether the Straddle section 1092 would apply under these circumstances. Our view is that Section 1092 does not apply. If it did apply there could be some very good tax advantages from having the cost basis of the ESOs reduced by the losses on the written calls.(n10)

11 Constructive Sale Rule 1259 (n11)

Since we never advise writing deeply in the money calls, the Constructive Sale rule will never be an issue. We also never advise doing conversions and will rarely advise doing collars where most of the risk of loss and potential gain have been eliminated. Doing collars versus substantially in the money ESOs is prohibited by SEC Rule 16c-4 for executives unless there would be an additional sale of a put with terms similar to the

ESOs.

Doing collars require the purchase of out-of-the-money puts which are generally substantially over priced, thereby adding to the costs of hedging. This is partly the reason we generally avoid doing collars. The other reason is that the -hedge lacks the risk reducing element of positive erosion which is gained from the pure writing of the slightly out of the money calls that we advise.

Lets take another example: as illustrated on the following graph.

On April 28, 2006, Google closed at 418. Assume that an employee had been

granted Google ESOs on October 20, 2005 to purchase 3000 shares at 350 per share

with immediate vesting. Expected expiration day is 5 years from the grant date.

12 Assume that on April 28, 2006, he chose to write 30 calls with a

of 450 which expire in January 2008. These calls were selling for $8300 per contract.

His net proceeds from the write would be $249,000. The delta on each call was .57

So the total delta on the calls written is -1710. This combined with the delta on the

3000 ESOs (30 x .82 = + 2460) equals a net delta of + 750.

On September 5, 2006 Google closed at $384.36. The Jan 2008, 450 calls closed and

could have been bought back at $4,010. So the stock dropped 33.64 points and

the calls dropped 42.90 points.

The calls which originally had a delta of .57 were down more than the stock. As with

Yahoo!, this was a result of not only the stock dropping but because of erosion and a

decrease in the “implied” volatility. The net result of the two positions would have

been in our estimation a gain of $37,872. The ESOs would have lost about $90,828

in theoretical value and the written calls would have had an un-liquidated gain of

$128,700.

If the Google employee has the ability to liquidate other stock positions that will

result in capital losses, he could use those losses to make the $128,700 of gain on the

listed calls not taxable on September 5, 2006.

Below are graphs that illustrate three different scenarios of management of 3000 Google ESOs with the stock starting at 418. The vertical axis measures the amount received at expiration on the blue and green graphs. The red graph shows that amount including the “time premium” remaining in the ESOs with two years life. Although the below graphs show writing listed calls equal to the same number of ESOs held, the more prudent strategy is to write listed calls equal to between 25-70% of the ESOs held. 13 • The blue graph shows the values of 3000 un-hedged ESOs at expiration. with an exercise price of 350. • The green graph shows the results of hedging the Google ESOs by writing 30 January, 2008 calls with a strike price of 450 at $8,300 each. Here we have the ESOs with a strike price of 350 expiring at the same time as the written January, 2008, 450 calls. • The red graph shows the results of hedging 3000 Google ESOs by writing 30 listed January 2008 calls at $8,300. Here the ESOs expire two years after the expiration of the written calls or 44 months from the day of the written calls. • No taxes were considered in these graphs.

14 Constraints on Hedging: Real and Imagined As far as we can tell, few of the practitioners in the ESO industry have substantial experience in trading stock options as a member of an exchange or as a manager of equities and derivatives portfolios. Therefore, the industry perspective is quite different from a professional trader’s perspective that we offer.

Below is a partial list of why these advisors claim that employees and executives are constrained from hedging their ESO positions;

1. The Options Plans or Agreements prohibit hedging.

2. Hedging defeats the purpose of the grants by reducing alignment of interests?

3. Large amounts of margin are required

4. There are SEC restraints on hedging by Section 16 executives

5 There are tax constraints, including the mismatching of tax treatments.

6. The Straddle Rule and the Constructive Sale Rule constrain hedging.

7. There are large transaction costs associated with hedging

8. Hedging is too complicated.

All of these constraints combined are not large enough to prohibit effective hedging, in our view.

15 Most of the remainder of this paper will explain these alleged constraints. Before going forward, we recommend that the reader review a paper by David Schizer

(now Dean of Columbia Law School) 100 Colum. L. Rev. 440 (March 2000) called:

EXECUTIVES AND HEDGING: THE FRAGILE FOUNDATION OF

INCENTIVE COMPATIBILITY., where Professor Schizer attempts to make a case against hedging employee/ executive stock options.(n12)

1. Seldom do companies have a complete ban on using options to hedge the risks of holding ESOs. But there are cases of companies who believe hedging defeats the purpose of the ESO grant. Allegedly, these companies want to forge an alignment of interests. Banning these hedging strategies essentially restrict the choices of ESO management and reduce the real and perceived value of the ESOs to the holders.

Those same companies allow and sometimes encourage the premature exercise of

ESOs and sale of stock, which reduces the alignment of interests much more than hedging the ESOs.

No reasonable person will argue that an employee who owns no ESOs or stock has a greater alignment of interests than an employee who owns substantially in the money

ESOs and is short out of the money long term calls. But that is exactly what the design of some plans assumes, when restricting hedging.

If a plan indeed constrains hedging employer stock and ESOs entirely, the employee can hedge by writing calls on the competitor’s stock or of several other companies that are positively correlated with the employer stock and achieve a reasonable hedge. 16

2. Do the grants of ESOs actually align the interests of executives or is the real reason to create a vehicle whereby officers and directors can reap extraordinary benefits for themselves?

Our belief is that a properly designed and properly administered Options Plan will align interests, especially one that prohibits executive abuses.

3. Are large amounts of margin required to hedge options?

Writing “naked” calls requires margin to be deposited in the form of cash or securities.

Using the CBOE page as a guide we find the following minimum requirements for various positions: See www.cboe.com/micro/margin/strategy.aspx

For example with the Stock Trading at 100, the following requirements apply for 1 call:

Position Description. Initial margin req. Maintenance margin req. Risk reduction ______

Short call ex.pr.110 $1000 = 10% of $10,000 $1000 Delta, Gamma, Theta, Rho

Short call ex.pr.100 $2000 = 20% of $10,000 $2000 Delta, Gamma, Theta, Rho

Collar 110 x 95 $1000 plus price of put $1000+ put Delta,

Long Put ex. pr. 95 Price of Put = $1130 Value of put Delta, (2 yr. 30 volatility)

Many holders of ESOs also own stock of the company. This generally allows the

writing of covered calls and up to twice as many out-of-the money naked calls with no

margin requirement. In fact, if they own stock, they may remove most of the proceeds

of the “writes” from their brokerage account whether covered or “naked”. If the

employee owns stock in a retirement account or an IRA he can write covered calls in

17 those accounts. Similarly, there would be no margin requirement in such accounts.

On the calls that are considered “naked” by the brokerage firm, if the stock increases substantially, there could be a margin call. The margin call could be dealt with easily and efficiently by buying back some of the shorted “naked” calls or exercising prematurely a small portion of the ESOs and either selling the stock or holding the stock in a margin account. Of course if proceeds of the sale were removed, those could be returned to cover any margin requirements.

4. Are there SEC Constraints on hedging?

SEC Section 16 b and Section 16 c of the 1934 Securities and Exchange Act apply only to officers, directors and owners of 10% of company equity. SEC Rule 10 b-5 applies to all buyers and sellers of securities.(n13)

a). Section 16 b is the statute which declares that any profits made by officers, directors and owners of 10 % of the stock as a result of trades of equity securities within 6 months are recoverable by the company (n6). Since we advise ESO holders to hedge by writing long term listed calls, we should not run into a problem with having to prematurely close positions or have the options expire before 6 months.

However, the ESO holder should be very conscious of 16 b when making any trades within 6 months of each other. Some claim that grants of ESOs are exempt from inclusion in the scope of 16 b, but we are not sure of that exemption. We believe that a strong case may be made that many ESO grants are not exempt. b). Section 16 c and Rule 16 c-4 make it illegal for executives to short sell their company’s stock or stock options(n14). However, the sale of calls is permitted to the 18 extent that the seller holds offsetting stock or substantially in-the-money ESOs. There is a private letter ruling from the SEC by Anne Krauskopf of the Office of Chief

Counsel of the SEC to Credit Swiss First Boston dated March 18, 2004 cited at: www.sec.gov/divisions/corpfin/cf-noaction/csfb031804.htm (n15)

This letter is in response to a request from CSFB to the SEC Division of Corporate

Finance to comment upon a package of trades to be made by CSFB with some of its clients.

The request is for a holder of substantially in-the-money vested non revocable ESOs to be allowed to do the following trades and be in compliance with SEC Rule 16c-4.

Those trades are: A) sell out-of-the-money calls and B) buy out-of-the-money puts and

C) sell other puts with the same exercise price and expiration date as the ESOs. The sale of out of the money calls and buy of out of the money puts is generally called a “collar”.

The SEC agreed that the above three trades together with the holding of substantially in the money vested ESOs was consistent with SEC Rule 16c-4.

Viewed differently, the four positions consisted of a long call vertical (in exchange lingo) and a long put vertical.. These positions would be slightly bullish on balance.

If the put positions were eliminated, the remaining position would be more bullish

We explained to Anne Krauskopf the nature of the CSFB positions and she agreed that the elimination of the put vertical would be more bullish, thereby complying with SEC

Rule 16c-4.

So if an executive owns substantially in-the-money vested ESOs and writes out -of -the- money calls, he should not be in violation of 16c-4. If he does a collar against the same in-the-money calls without the sale of the extra put, he is in violation of 16c-4. 19 SEC Rule 10 b-5 should not be a problem to comply with in hedging ESOs with listed calls any more than 10 b-5 represents a problem to comply with when trading stocks.

5. Are there tax restraints including the possible mismatching of gains and losses that make hedging risky?

Some critics of hedging with listed call options set up a straw man to shoot down.

Here’s the scenario:

They assume that the stock is trading at 10 and an employee owns ESOs to buy 1000 shares of stock at 10. They assume the employee writes 10 listed calls with a strike price of 10. They also assume that the stock then increases to 100 making it such that the employee has a large loss on the written calls and a large gain on the ESOs (perhaps a

$87,000 loss on the calls and a $90,000 gain on the ESOs).

Since the loss will probably be a short term capital loss and the ESOs will show compensation income, the tax treatments will be mismatched.

The after tax results will be the following:

a) Ordinary income from the ESO = $90,000 b) Ordinary tax at a 40% rate = $36,000 c) Capital loss on the call writes = - $87,000 d) Tax credits from Capital loss = $1,200 per year e) Capital tax loss carry forward after year one = $84,000

Total current loss after tax = - $34,800

That certainly is not a good result. But what is the probability of a stock being above 100 when it started at 10 perhaps 6 years ago? The chance is about 1 in 300 with a stock with a .30 volatility. These critics use a 1 in 300 shot to criticize the hedging strategy. If they used a 10-40 scenario, the chance was still a 1 in 33 shot (n5) 20 But we do not advise selling at-the-money calls on 100% of the ESOs. We advise writing slightly out-of-the-money calls against in-the-money ESOs and often advise writing calls on only 50-70% of the total ESOs owned. And we timely adjust the position deltas to be always substantially long deltas.

So the mismatched tax treatments as an objection is not well taken under these circumstances. The well informed hedger can use listed calls to get tax advantages.

The gain on the writing of calls would be short term capital gain. If there are other capital tax losses to be used against those gains, then there could be no tax at all on the profit from the written calls.

In view of all factors, hedging by writing calls against ESOs can be tax friendly to the employee/executive.

6. Straddle Rule and Constructive Sale Rule.

These rules have been addressed in an earlier part of the paper. Essentially these rules

will have just a very small impact if the hedging of ESOs and stock are done correctly.

7. Are there large transaction costs associated with hedging.

Hedging ESOs by writing listed calls can be done for as little as $1.00 per contract. With

TradeKing, the cost of selling 100 listed options contracts (i.e. contacts to buy 10,000 shares of stock) is $75.00 in total online.

If you wish better executions and true experts to manage your positions, it will cost more.

21 8. Is Hedging too complicated? It’s true that hedging is more complicated than the strategy of premature exercising and selling. But it’s a lot less complicated once the employee reads a few articles on our web site www.optionsforemployees.com/articles

Here is what should be done. Find a broker who will allow you to sell naked calls for the minimum margin requirements determined by the CBOE. Most brokers will not assist for various reasons. But there are some very good brokerage firms that want your business. When you have found the appropriate broker, deposit any shares of stock into your account and tell them to open a margin account. You are now ready to sell “qualified covered calls” and naked calls.

Locate the calls with the longest time remaining that are slightly out of the money that have bids and ask prices that are not too wide. If for example: the market is 5 bid at 5.20, that’s a pretty good spread. Place a limit order to sell calls at 5.10 and leave it in. If the stock moves a bit higher, raise the asking price if you have not gotten a fill.

Much can be saved by avoiding market orders when writing calls. Always use limit orders or “not held” orders if you have a good broker. When you get a fill, tell the broker to send you the proceeds immediately if you have excess collateral.

After the stock moves around and time has past, there are generally adjustments to be made which will require an understanding of many of the concepts incorporated herein.

22 Comparison of Writing of Listed Calls with Using Collars to Hedge ESO. Margin Requirements. Determined by Self Regulatory Organizations acting together.

Assume that we are comparing the naked write of a 2 year call, with an exercise price of

110 when the stock is trading at 95, with a 2 year naked collar consisting of a sale of the same call and the purchase of the put exercisable at 90. The assumed volatility of the stock is .30.

The initial margin requirement to make the sale of the call is 10% of the market value of the stock (i.e. $950 to sell one call on 100 shares of stock).

The initial margin to do the collar is $950 plus the market value of the put. In this case, the market value of the put is about $1070. So to do the collar on 100 shares requires an out of pocket amount of $2020.

If the stock advances, there would be a call for additional margin in both cases equal to the same amount.

If the stock decreases, the initial margin is reduced in both cases by the same amount.

Credits to Margin Account.

Upon the naked write of the call only, there will be a credit equal to the market value of the call (approximately $1434) to the writers margin account. The margin deposit of $950 would also be a credit to the writers margin account.

When the put is purchased, the $1070 is paid to the OCC which pays the $1070 to the writer of the put. There is no credit to any account when the put is purchased.

In both cases, the hedger will earn interest on the margin accounts credits.

23 Delta Risk Reduction. The negative deltas achieved by the sale of the call in these circumstances is perhaps -.55.

The negative deltas achieved by the purchase of the put is perhaps -.32.

The negative deltas achieved by the collar is the total of -.55 -.32 = -.87.

Deltas per dollar of margin outlay equals -.55/950 = - .58 on the write of the call

Deltas per dollar of total outlay equals -.87/2020 = -.43 on the collar.

Gamma Risk Reduction.

Selling calls give negative gammas. This reduces the risk of holding positive gammas in the ESOs.

Buying collars is approximately neutral to positive gammas, thereby not reducing the positive gammas in holding ESOs.

Theta Risk Reduction.

Selling calls adds positive thetas to the negative thetas of holding ESOs thereby reducing risks.

Doing collars does not significantly add positive thetas and therefore reduces very little the negative theta of holding ESOs.

Rho Risk Reduction.

Selling calls reduces the Rho risk of holding ESOs, doing collars does not.

Theoretical Advantages.

Generally, the sale of the out of the money calls (although often slightly under-priced) is a superior trade theoretically than the purchase of the out-of-the-money put. 24 Conclusion:

Hedging by writing listed calls will reduce risk and taxes and may produce much greater earnings than other strategies. Hedging is not substantially restrained by contract or law.

Nor are there logistical considerations that may make hedging impractical.

John Olagues …………………………Ray Wollney……………………..

------

25

Footnotes 1. Thomas J. Boczar CFA: The Monitor: The Voice of the Investment Management Consultants Association September/October 2006 pages 22-26 www.imca.org ; Mark A. Miller J.D. CFP Hedging Strategies for Protecting Appreciation in Securities and Portfolios FPA Journal August 2002.

2. J. Cox and M. Rubenstein, “Options Markets” (Prentiss Hall Inc 1985) F. Black and M. Scholes, “The Contracts and a Test of Market Efficiencies,” “Journal of Financial Economies,” 399-418 (May 1972).

3.Statement of Financial Accounting Standards 123 (revised 2004).

4. A. Elizabeth Whalley: Should Executives Hedge their Options and if so How? January 2006. Warwick Business School, University of Warwick, Coventry

5. Peter Hoadley’ Tools: Stock Price distribution Analysis. www.hoadley.net/options/probgraphs.aspx

6. Section 16 (b) of the Securities and Exchange Act 1934, 15 U.S.C. section 78(p)(b).

7.CBOE website: www.cboe.com/micro/margin/strategy.aspx

8. The 3000 Jan 2008 35 calls would have increased from 42- 45 cents with the stock moving to $34.5 over four months, giving the writer a 42-45 cents loss. The implied volatility dropped 1.25-1.50 points for the 35 calls after four months. The loss on the 3000 calls would have been $125, 000 -135,000. The gain on the 100,000 shares would have been $250,000 and the gain on the 2000 ESOs would have been about 2 points in theoretical value or about $400,000. There was also a gain of 1.2% on the $1,540,000 over the 4 months or $18,000. The total would have been a gain of $500,000 -550,000.

-$135,000 Written Calls +$250,000 Stock +$400,000 ESOs +$ 18,000 Interest +$533,000. Total

9. IRC Section 1234;

10. 26 CFR Chapter1 section 1.1092 (c) -1. and Section 1092- (d)(1), (2) and (3). And Joint Committee on Taxation, Description of the tax Technical Corrections Act of 2006(JCX-48-06), October2, 2006 page 8 “Under Code section 1092, the term ‘straddle’ means offsetting positions in actively traded personally property.”; IRS Publication 550(2006), Title 26 IRS section 1.83-7 Taxation of Non Qualified Stock Options i 11. USC Title 26 Section 1259 Constructive Sales Treatment for Appreciated Financial Positions.

12. Schizer, David, 100 Colum. L. Rev. 440 (March 2000).

13. 17 CFR 240.10b-5 and 17 CFR 240.10b5-1

14. 17 CFR 240. 16c-4

15. Credit Swiss First Boston private letter ruling March 18, 2004

ii APPENDIX

Definitions

At-the-money. The stock is trading at or very near the option’s exercise price.

Back-dating grants. Changing the exercise prices favorably for the executives by back- dating the grant date to a time when the stock price was lower.

Back-Dating Exercises. Changing the exercise dates to turn some income from ordinary to long term capital gain

Bearish position. A position in stock or options or the combination of the two that has a summed total of negative deltas. Holders of Bearish positions are hoping for a drop in the stock price.

Black Scholes Model. A theoretical options pricing model recommended by FASB and the SEC in calculating “Fair Value” of ESO grants to employees for expense purposes. The model assumes that the returns on stock are normally distributed and that expected volatility, interest rates, and dividends do not change over the life of an option

Bullish Position. A position in stock or options or the combination of the two that has a summed total of positive deltas. Holders of Bullish positions are hoping for and will profit from a rise in the stock price. A Bullish position made up of short puts may be profitable even when the stock does not rise.

Call A listed option giving the holder the right, but not the obligation, to buy stock at a specific price over a specific period of time. Calls are similar to ESOs but are issued by the Options Clearing Corporation, whereas ESOs are issued by the employer. Listed calls are liquid and have standardized terms. ESOs are illiquid and have tailored terms, generally with 10 years of life. The value of an ESO is purely theoretical.

Closing Transaction. For our purposes, means the buying back of a call that was sold at an earlier time.

Collar. A combination of a sale of an out-of-the money call plus a purchase of an-out-of- the money put generally transacted versus a long position in stock. Collars do little to reduce the erosion risk or the risk of changing volatility or interest rates. A collar reduces delta risk but not gamma risk. Generally, buying a collar requires a concession in theoretical values. In ten years of trading options on the CBOE and the PSE, we never bought a collar or witnessed a trader ever buy a collar for any purpose. Some believe that collars versus vested substantially in-the-money ESOs are consistent with Rule 16c-4. We believe that to be true, only in combination with an additional sale of a put with exercise date and price equal to those of the ESO. (n14)

A1 Constructive Sale. The hedging of a that has the effect of removing all upside potential gain and downside risk. Constructive sales cause early tax liabilities. Seldom will the Constructive Sale Rule apply to hedges versus employee stock options, in our view, given that ESO values are always theoretical and there is generally no market value for ESOs.

Covered Call. A call that is written to offset a long position in the stock, which reduces risk and potentially increases income. A write of a reduces the potential gain on the underlying equity security.

Delta. The amount that the “Fair Value” of an ESO or listed option is expected to change in the short run with a one point movement in the underlying stock price. Deltas change as the stock price changes or time to expiration erodes the time premium.

ESO. Employee Stock Options.

Erosion. The “time premium” or “time value” will erode over the life of the option. Some call this erosion the “theta” risk.

Exercise Price. The price that is designated in the ESO agreement at which the employee has the right, but not the obligation, to purchase the underlying stock, often called the strike price. The closing market price on the day of the grant is generally the exercise price.

Expected time to Expiration of ESO’s. An amount of time to expiration of ESOs which considers the differences between ESOs and listed calls. Generally it equals about 60-80% of the nominal time to expiration. The expiration date may be reduced by the options agreement to as little 90 days after a termination.

Expiration Date. The date after which an employee or investor can no longer exercise his ESOs or listed options. This date may change when the employee terminates early.

Fair Value. The value ascribed to ESOs using theoretical pricing models having made proper adjustments suggested by FASB and the SEC.

Fair Market Value. The market price or a price at which fully informed honest buyers and sellers are willing to trade a security.

FASB. The Financial Accounting Standards Board.

A2 Forfeiture of Time Premium. This happens when ESOs or listed calls are exercised prematurely. The company will receive the forfeited time premium in the case of ESOs.

Gamma. Means the rate of change of delta.

Grant Date. The date on which an agreement is made between the employer and the employee whereby the employer grants to the employee the right to purchase specific amounts of employer stock in exchange for the employee’s contributions to the company.

Hedge. Is a transaction or series of transactions that are designed to reduce risk, take profits or delay taxes, with the understanding that some or most of the potential gain is reduced by the hedge. Some trades reduce delta risks but increase theta risk. Examples are buying puts versus stock or ESOs. Selling the underlying stock versus holding ESOs is a hedge against delta risk of the ESOs. Selling appropriate calls versus ESOs reduces delta, theta, and gamma risk and most any other risk that can be conceived of.

Hedging Naked ESOs. The most prudent way to manage ESOs, if the holder is risk averse and wishes to minimize risk and maximize the ESO’s returns.

In-the-money. When ESOs and listed calls have an exercise price below the current market price of the stock, the options are-in-the money.

Intrinsic Value. The amount that the stock price is above the ESO or listed call exercise price at any given time. Upon exercise there will be a tax on the intrinsic value of the options (i.e. in the case of non qualified ESOs).

Log-normal stock prices. Most theoretical pricing models assume that future stock prices are distributed log-normally.

LEAPs. Long term listed equity options.

Listed Options. Options traded on various exchanges. These have standard terms for exercise dates and strike prices and are highly liquid.

Market-maker. A member of a national options exchange who trades stock options and stock while physically on the options floor. He has obligations to provide reasonable markets to the trading public in various classes of options.

A3 Naked Option. Means 0ptions that are un-hedged. These involve high risk. Un-hedged ESOs are naked options.

Out-of-the-money. These options have a strike price above the current market price of the stock.

Premature Exercise. When ESOs or listed calls are exercised prior to expiration day. It is the primary error that holders of ESOs make. It forfeits the remaining time premium to the company and causes an early tax liability.

Qualified Covered Call. These are calls that are out-of-the-money with longer than 30 days and less than 33 months to expiration, that are sold to hedge long stock positions. The Straddle Rule does not apply to “qualified covered calls”.

Re-load Provision. A clause in an executive’s Option’s Agreement that grants new ESOs to the executive upon exercise of his earlier granted ESOs.

Restricted Stock. Stock granted often to employees in lieu of cash compensation. This stock can not be immediately sold in the open market.

Rho. The expected change of the theoretical value of an option for a 1% change in the interest rate.

Rolling forward. This refers to buying back nearer term written calls or puts and simultaneously writing longer term calls or puts, which may be more appropriate in terms of risk reduction, taxes and theoretical value considerations.

Spring-loading. When executives time the grant of options prior to positive news that is expected to advance the stock.

Straddle Rule: This is a rule designed to eliminate tax abuses by the use of offsetting stock or listed options positions. Some accountants claim it applies to ESOs versus written listed call options. Our view is that, given how the ESOs are generally structured, the straddle rule will rarely apply.

Theta. Means a measure of the rate of change to an options theoretical value for a one unit change in time to an option’s expiration date.

Theoretical Value. This is the same as the “Fair Value” of ESOs suggested by FASB and the SEC. The concept of theoretical value applies to listed options as well ESOs. In theoretical ESO calculations, expected time to expiration rather than nominal time to expiration is used in consideration of expected early terminations and premature exercises. Some appraiser make discounts for lack of liquidity. A4 Time Premium. Is that part of the value of an ESO or a listed option which is above the intrinsic value of the options. The time premium is forfeited on premature exercise. Some refer to time premium as “speculative value”.

Underlying equity security. Is an existing equity security that relates to or is the subject of an option. The underlying equity security of a SARs settled in cash is the existing, issued stock. Some claim that the underlying equity security of an option is only the stock that may be received upon exercise of that option.

Vest. .Options and sometimes restricted stock are said to vest in the employee after a specific period of time. As the options vest, he is allowed to own and exercise the options or sell the formerly restricted stock

Volatility. In technical terms, volatility is the standard deviation of returns. To the general public, it means the amount the stock price is expected to move. Volatility is used as an assumption input into the theoretical options pricing models. When the market value of options is different from theoretical value, traders refer to the concept of “implied” volatility as an explanation.

Write Calls. To sell listed calls, either covered or naked, in an opening transaction. When calls are sold the proceeds are credited into an account to be removed, re-invested or to earn interest. .

A5 John Olagues, is the owner and principal consultant of Truth in Options

John was born in New Orleans in 1945, graduating from Tulane University with a B.A in Mathematics, where he was an All- American baseball player. His first job after a short stint in the minor leagues was as a pension consultant for the Continental Assurance Co. He next entered the world of warrants, stock options and other derivatives as an A.G. Edwards registered representative and later as an investment advisor.

In 1976, John became a member of the Pacific Stock and Options Exchange and a member of the Chicago Board Options Exchange in 1981, trading options as a market maker for over ten years. Along with Blair Hull he created, Options Research, the first analytical service to theoretically value listed options for market makers and the general public.

For years he was one of the leading options traders in the world, creating many of the options trading strategies used today by market makers world wide.

He retired from market maker activities in the late 1980’s and stopped along the way to build high-end spec homes in Marin County and later built and operated a luxury hotel in the Bay of Islands, New Zealand

Since 2003, he has focused on the employee stock options arena, creating Truth In Options, www.optionsforemployees.com. Essentially he applies the strategies learned as a market maker to the management of Employee Stock Options.

He has just recently invented a New World Stock and Options Plan, which he believes will substantially improve on most plan designs.

His email is [email protected] Phone 949-903-6698 or 504-324-6698