The predominant strategy that "Options Advisors" urge in managing Employee Stock Options is a naive form of "premature (i.e. prior to expiration) exercise" of the options. They then advise the sale of all or part of the stock received. In some cases, they may advise the the hedging of the received stock with listed calls, puts or "collars". This advised hedging is generally against stock received from the exercise of Qualified Employee Stock Options.

It very seldom makes sense to exercise your ESOs prematurely, whether your intention is to sell the stock immediately or to hold on. Premature exercising forfeits the remaining "time premium" back to the employer. Premature exercising of ESOs should be a last resort.

First, I will give a short explanation as to what an option is and then compare the various choices available to employees or executives as time passes and the stock moves up or down.

An option granted to an employee or executive to purchase stock can be conceived of as having two parts.

1. The first part is the Intrinsic Value of the option. This equals the difference between the market price of the stock and the exercise price of the option (assuming that the market price is greater than the exercise price). The Intrinsic Value is never less than zero.
2. The second part is the Time Premium of the option. This equals the value of the option over and above the Intrinsic Value. At the time of the granting of the option, there is no Intrinsic Value since the market price is generally equal to the exercise price. So, at the time of the grant, the value of the option consists entirely of Time Premium. The value of the option at any particular time depends on the probability of the stock trading at prices above the exercise price on expiration day and some time prior to expiration day. This probability depends mainly on the volatility of the stock, the time remaining to expiration day and the current price of the stock relative to the exercise price.

As time passes, if the stock price increases, there will be intrinsic value but there still remains time premium as long as there is time remaining to expiration. 

Mathematicians Fischer Black and Myron Scholes created a model to price options’ values, for which they were awarded the Nobel Prize. This model is often used to value listed and employee options, with ajustments unique to employee stock options.

Whenever an employee exercises his options, he forfeits any remaining time premium. Upon exercise, he essentially gives back to the employer an amount of money equal to the time premium. The return of the remaining time premium to the employer takes place because the liability that the employer assumes at grant day is reduced upon an early exercise. The employers liability equals the remaining time premium plus the intrinsic value. The premature exercise reduces the employers liability by an amount equal to the time premium.

The employee also incurs an early tax liability either upon exercise (in the case of non -  qualified options) or upon sale of the stock (in the case of qualified options).

Comparison of Choices:

We will now compare the CHOICES A, B, C, D, E, F that are available to the employee or executive as the stock increases in value.
 
But first, we make certain assumptions as below. These assumptions can be changed to meet individual situations.

Assumptions:

1. Employee owns options to purchase 1000 shares of ABC company.
2. The options are vested and have 5 years of expected life remaining to expiration.
3. The options are non- qualified. (Qualified options are treated differently for tax purposes.)
4. The assumed volatility of the stock equals .30 and there are no dividends.
5. Exercise price is 20.
6. Market price is 40.
7. Employee’s marginal tax bracket is 40% including state and federal taxes.
8. The theoretical value of the options to purchase 1000 shares at $20.00 per share under the above assumptions is $ 24,000.00 (i.e. $20,000 Intrinsic Value + $4000 of time premium) according to Black Scholes.
9. The employee or executive is not restricted by contract from hedging his options positions. Restricted owners have less choices.
10. The employee has additional assets and does is not forced to liquidate his options immediately to raise cash.

CHOICE A

Exercise all the options and immediately sell all of the stock.

Net Results.

+ $20,000.00 gross proceeds ($40 - $20 x 1000)
- $  8,000.00 for taxes (.40 x $20,000)
+ $12,000.00 net proceeds

There is no further risk and no potential profit. Employee nets $12,000.00
from his options valued by Black Scholes at $25,000.00.

This predominately is the choice advocated by most advisors.

This choice favors the employer because the liability that the company had. It was valued at $25,000.00 and was reduced to $20,000.00 upon exercise. The employer also  received an immediate tax credit in the case of non qualified options - equal to the $8000 above that the employee may be required to pay.

CHOICE B

Exercise all options and hold all stock.

Net Results.

- $20,000.00 to pay for the purchase  ($20 x 1000)
- $  8,000.00 for taxes (.40  x  $20,000)
- $28,000.00 total out of pocket costs to purchase stock and hold stock

Of course he could fully margin the stock and use the $20,000 to pay the exercise price.

Employee now owns 1000 shares of stock worth $ 40,000.00

He has unlimited potential for gain on the upside and can lose $40,000.00 if the stock goes to zero. He no longer owns the options, which were worth  $25,000.00 according to the Black Scholes model. He has essentially traded in his options for a $12,000.00 equity position in the stock.

If the options were qualified options, there would be no immediate tax liability and there would be no need for the immediate $8,000.00 tax payment. His equity is then worth $20,000.00 with a potential tax of up to $8,000.00 when the stock is sold. He would have to pay whatever was required as AMT

This choice also favors the employer for the same reasons as in Choice A

CHOICE C

Exercise no options, pay no taxes, and keep the remaining time premium and intrinsic value.

Employee has unlimited potential gain on the upside and can lose the $25,000.00 value if the stock is below $20 per share at expiration day. Although risky, this is superior to A and B.

CHOICE D

Employee does not exercise the options but wants to reduce the risk of holding his employee stock options “naked”.

He sells or “writes” listed out- of -the - money long term calls (i.e. LEAPs) with two years of life to expiration. The proceeds would be approximately $5,800.00 for ten LEAPs exercisable at $45 dollars per share for 1000 shares.

There are no taxes due upon sale of the listed options. Taxes will be assessed depending on whether the “write” results in a profit when closed or the LEAPs expire.

The employee must advance cash equal to $4,000.00 or sufficient marginable securities. Interest is paid to the “writer” on the cash deposit and the proceeds of the “write”.

If the employee owns employer stock he can use that stock as collateral and receive immediately the proceeds from the "write" by check.

This hedge against the “naked” long ESOs reduces the risk on a down move and still keeps much upside potential.

If the employee wants more downward proctection and is willing to sacrifice more upward potential, he could "wrtie" options with lower strike prices and receive a bigger check if he owns employer stock as collateral.

Any hedging transaction results in reduced potential gain. However, this does not necessarily reduce the expected return. If done properly, hedging can in many circumstances reduce risk and increase expected returns. How this is accomplished is beyond the scope of this article but it most certainly can be done.

 CHOICE D is a superior choice compared to the above CHOICES A, B, or C.(ft 2 , 3)

CHOICE E

Employee does not exercise the options but wants to reduce the risk of holding options “naked” and is concerned about an extreme downward move.

Employee reduces the number of calls sold as in choice CHOICE D above and adds the purchase of out of the money puts (i.e. LEAPs) to further protect the employee options position.  With the stock at 40, it would be appropriate to buy the puts with a strike price of $ 35. The sale of out - of -the - money calls and the purchase of out - of - the money puts is referred to as a “collar”. If he owns employer stock, he merely reduces the check he receives by the amount of the put cost.

There would be no taxes upon initiation of the “collar”. Taxes are assessed if there is a gain when the position in whole or part is closed at a profit.

The “collar” reduces the upside potential more than the “write”. It works out very well if there is a large down move. This strategy does not reduce the erosion risk associated with holding the "naked" ESOs as does choice D.

This is superior to Choice A in most cases regardless of what the stock subsequently does (ft 2,3).

CHOICE F

This choice deals with using a sale of single stock futures to hedge against the “naked” long employee stock options.

This strategy is similar to shorting the stock. The advantage of using the single stock future rather than short sales is that the margin requirements are lower and the seller effectively earns and receives interest on the full amount of the proceeds from the sale immediately. (ft 2,3)

The margin to short sell 1000 shares at $40 is initially $20,000. In the case of selling 10 single stock futures it is $8,000.  

This strategy may cause a constructive sale if the seller owns stock. It may also be prohibited by SEC Rule 16 if the seller is an officer or director and he does not own stock.

Summary

It is clear, from the examination of these CHOICES A, B, C, D, E  and F, that CHOICES D, E, and F are superior to the premature exercise strategies of A, B.

This is the case partly because of the fact that the D, E, F and strategies incur no immediate tax liabilities.

It is also the case that not exercising the options as in C, D, E, and F preserves the time premium. In cases of higher volatilities, the time premium is often greater than the intrinsic value even when the stock is substantially above the exercise price.

The strategies of D, E, and F work better in high volatility stocks with no dividend payments and several years remaining to expiration.

To accomplish these strategies efficiently, you are required to do some study and work. Initially you would need Truth in Options to consult and guide you.

The reward from using these methods, of course, depends on the size of your holdings and the relative importance that your employee stock options have in your portfolio of investments.

In closing, these strategies are not beyond the capability of anyone. Consultants from Truth in Options have in the past consulted and trained people who knew nothing about options and subsequently became experts.

Black Scholes Theoretical Value (1,000 shares).
This page illustrates how the theoretical values of the options change as the stock price changes over time from $10-$60. For example if the stock price is $50 with 3.3 years of expected time to expiration, the value of the options to purchase 1000 shares at $20 per share equals $34,740.

Theoretical Value Components (1,000 shares).
This page illustrates how the Intrinsic Value (defined as the difference between the exercise price and the market price of the stock) changes as the stock price changes over time from $10-$60. This page also illustrates how the “time premium” decreases as the stock rises substantially “in the money”. The “time premium” also decreases as the time remaining to expiration decreases.

Exercise and Sale Impact (1,000 shares).
This page illustrates the consequences of a premature exercise of options and sale of stock. The time premium is effectively forfeited. Federal and state taxes are immediately assessed at the ordinary rate. For example: if an employee exercises options to buy 1000 shares at $20.00 per share when the stock price is $40.00 per share with 4.3 years of time to expiration, he will net only $12,000 after taxes. Even though the actual value is $26,460.

Note: Time premiums would be less if the assumed volatility or the assumed time remaining to expiration is less than shown.

See the chart below, which illustrates the time premiums as we change the volatility and time to expiration:

Stock       Strike        Assumed         Expected Time      Time Premium
Price        Price         Volatility          to Expiration          (1000 shrs.)
   
60               20                 .50                   2.3 yrs.               $1945.00 

50               20                 .40                   3.3 yrs                $ 2667.00

40               20                 .30                   4.3 yrs                $ 3092.00  

30               20                 .27                   5.3 yrs                $ 4365.00

THESE GRAPHS AND NOTES PROVE THAT THE OPTIONS SHOULD NOT BE EXERCISED UNTIL NEAR EXPIRATION DAY.  (Of course in some rare events, the early exercise can be the most efficient procedure).

Footnote 1. In the case of pending mergers or takeovers or large dividend payments it can be wise to exercise the ESOs prematurely.

Footnote 2. Strategies D and E are available only on stocks that have listed traded options. Private contracts can, in fact, be negotiated. However, the terms will be less favorable to the seller and there may be loss of all liquidity.

Footnote 3. Restrictions apply to Officers and Directors of Companies in applying some or all of these hedging strategies due to Rule 16 considerations.

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.