The Objects of this article are..

• To create a simple strategy, whereby the employee can

exit his options positions in a highly efficient orderly manner.

• To maximize the value of the employee options to the

employee and reduce taxes.

• To reduce the employee’s risk throughout the life of

the options.

• To help the employer accomplish the objectives of the 

stock options plan by maintaining the alignment of

employee interests with the employer’s interests through-out

the life of the options.

Stock options are still the largest element of equity

compensation.

Some contend that as many as 14 million U.S. employees own

stock options on their employer’s stock. In addition, ESOs are

granted to millions of employees in China, Russia, Malaysia,

Europe, Japan, Canada, India, Great Britain, and Australia

and more.

A whole industry has grown up around employee stock options

and related equity compensation plans.

Major associations such as the National Association of Stock

Plan Professionals (NASPP), the National Committee for Employee

Ownership (NCEO), the International Employee Stock Options

Coalition (IESOC), the Coalition to Preserve and Protect Stock

Options, the Foundation for Enterprise Development, the

Employee Stock Options Advisory Association (ESOAA), the

ESOP Association of Canada and more have been created

to deal with the design, the installation and the

administration of these stock options plans. Some offer tax

advice on how to handle the options once received.

There is even an organization called the National Board

of Certified Option Advisors (NBCOA), which claims to

train and certify Option Advisors.

The members of these organizations are mostly tax

lawyers, accountants, human resource personnal,

compensation consultants, a few account executives,

financial advisors and marketing personal.

One area that these professionals know very well is the

tax treatments of ESOs, ESOPs, Restricted Stock,

retirement plans etc.

They generally know how to design and efficiently

administer those plans, hoping to achieve the objectives

of the employer and avoid costly employment litigation.

Some know the complicated pros and cons of expensing

options for financial accounting purposes.

Some even have a working understanding of the theoretical

options pricing concepts.

Those administrators are also required to explain to the

employees what the plans and the options are all about.

There is one area that only a few will venture into,

however. That is the area of “How The Employee Manages

His Options ” once granted.

If an advisor who claims experience can be found, he

usually advises some form of systematic premature

exercise of the ESOs with the immediate sale of some

or all of the stock. He then advises using the proceeds

to diversify the employee's investments.

Some even promote the purchase of listed puts or "collars"

to hedge the stock received upon exercise. One or two

promote the buying of puts to supposedly reduce the risk

prior to exercising the options.

The idea of selling listed call options to hedge those employee

stock options, prior to exercise, is virtually taboo.

Why is that the case?

The reason is that there are very few people in any of those

organizations who have had substantial experience trading or

managing listed stock options portfolios. They are afraid of

the area because they do not know it and they are not willing

to consider alternative strategies that contradict what they

believe is set in stone.

Your writer, however, is a persons who has extensive

experience trading and managing listed options. He will

presents his advice as how to manage employee stock

options from the viewpoint of having personally traded

an average of 3000 options contracts (i.e.options on

300,000 shares of stock) per day for perhaps ten years

as a member of the CBOE and PSE.

Truth In Options' strategy will generally outperform any

strategy offered by those advising a system of “premature

exercises” as an exit strategy.

Preliminary Required Information.

Before proceeding, employees must understand all the

details of his employee options contract. All practitioners,

regardless of their methods or advice, agree on this point:

You should:

• Know the exact number of options that you have been

granted and still hold.This will give the equivalent stock

position that you hold.

• Know the exact exercise prices and expiration dates of all

of your options granted and held. You will need this information

to determine how to capture the maximum time premium.

• Know the vesting periods and penalties for early

termination after vesting. This will tell you how much you will

lose when you terminate and help you take actions to reduce

the impact.

• Know your expectations of longevity with the employer.

Your expected longevity helps you determine the value of the

options to you.

• Be aware of all your recent capital gains and losses both

liquidated and un-liquidated stock or listed options. Capital

losses can be used to reduce short term capital gains from

the sale oflisted options if you hedge against capital assets.

• Understand whether your options are qualified or

non-qualified options. This helps with taxes and hedging

strategies.

• Understand the tax treatments of your options upon

exercise and hold and exercise and sale.

• Anticipate whether you will be granted more employee

stock options in the future. This will help you plan for risk

reduction and management of your options.

• Understand your stock position in company shares owned

outright or in retirement plans or trusts.

• Know what portion of your entire estate is invested in

employer equities. Be thinking about diversity after your

employee options are exercised.

• Understand whether hedging is allowed by the employer

for risk reduction and taking profits. If hedging the ESOs are

prohibited, your choices become severely limited. Your

strategy would be different since you may not even be allowed

to write listed calls on the employer stock.

• If you are an officer or director for your employer, you must

know how Section 16 b and SEC Rule 16b-3 applies to you as

a grantee of ESOs. You must also understand how Section 16 c

and SEC Rule 16c-4 applies.

• You must also understand whether there are any company

restrictions on the timing of your trading.

• Understand your attitude towards risk. Do you want to

reduce risk or are you a speculator?

• Will your hedging of your options be viewed as

expressions of negativism toward the company’s future?

• All of the above information should be understood if

you wish to properly value and make decisions that maximize

the value of employee stock options.

Preliminary Discussion.

Unless specifically stated otherwise, the below discussion deals

with Non-Qualified options.The assumption is that the restrictions

against hedging are not prohibitive. The ideas expressed can be

applied by executives ( i.e. officers, directors and holders of more

than 10% of the company stock) although executives must be

concerned with SEC Section 16 implications and with SEC

Rule 10 b 5) more so than non - officers and directors.

Options Components

Stock options consist of two distinct concepts whether the

options are listed are employee options. Those concepts are

intrinsic value and time premium:

“Intrinsic value” equals the difference between the current

marketprice of the stock and the exercise price of the options.

When you exercise and sell, you receive this value minus

the tax.

“Time premium” equals the value of the options above the

“intrinsic value”. This equals the value due to the probability

that the intrinsic value will increase over time. It’s value is

calculated by theoretical pricing models. Some of the

“time premium” is often forfeited by most of the promoted

methods of managing employee options.

Strategy:

Our strategy is to indirectly capture 100% (or more) of the

“time premium” and "intrinsic value" by systematically "writing"

listed long term calls. Of course, holding the employee options

unhedged to expiration day in effect “captures” the

"time premium" and "intrinsic value", but our strategy also

reduces much of the risks of holding the options to expiration

day and we believe it can capture more than 100% of the

"time premium".

We also seek to reduce taxes to as low as possible.

We accomplish these objectives by avoiding “premature

exercises”.

A “premature exercise” causes a forfeiture of the

“time premium” and an early and sometimes unnecessary

tax liability.

We emphasize one principle over all others.

AVOID PREMATURE EXERCISES OF EMPLOYEE STOCK OPTIONS.

Our estimate is that by avoiding premature exercises and

expertly selling (i.e. writing) listed call options to capture

the “time premium” and to reduce taxes, you will generally

achieve a 40% to 50% average after tax expected gain

over what you would achieve by most other systematic

“premature exercise” exit strategies.

Beginning Comments

When options are granted, the initial position is one of

long delta’s (i.e. bullish to an equivalent stock position )

with negative theta’s (i.e. erosion of the time premium).

This means that your options lose value if the stock goes

down, stays the same or appreciates slightly. We propose

that an employee take an aggressive attitude toward

reducing delta risk and theta risk.

However, in the early days after the grant, we advise just

minor risk reductions, given that at grant day none of the

options are vested.

We also do not want to interfere with the object of the

options grant by substantially reducing the alignment of the

interests of the employee with the interests of the employer

early in the employment contract.

Hedging Step 1.

Immediately after being granted the ESOs, the employee

should sell (i.e. write) listed calls equal to 7% of the

number of options he has been granted. If he holds

substantial stock of the employer, he should

sell additional listed call options equal to 7% of the

stock held.

At this point his total positions are very bullish and highly

speculative, but less so than before he hedged. His risks have

been reduced by approximately 5-7% compared to the time

before he sold the listed calls. His upside potential profit has

been reduced accordingly. We advise selling the longest listed

LEAP calls, which have exercise prices greater than or equal

to the exercise prices of the granted employee options.

However, the employee may want to sell different exercise

prices depending on how much he wishes to reduce or

maintain the delta and erosion risks.

Hedging Step 2.

In the next year he would sell the same number of

listed LEAP calls as in the first year, while maitaining

the previously established short call positions. Again,

after the sales of additional listed calls, his risks

and potential gain have been reduced accordingly.

Perhaps he has become vested in at least 20% of the

options at this point.

Hedging Step 3.

In the next year, he would again consider repeating the

selling of 7% more calls as above, depending on his

attitude toward risk and where the stock is trading relative

to the exercise prices.

Hedging Step 4.

In the next year, he would repeat the selling of 7% more

calls consistentwith the above steps. By this point,

some of the options positions are probably showing a

substantial gain and some showing a loss. It would be

wise to liquidate some of the losses and sell longer LEAP

calls as part of the strategy of reducing risk and taxes.

Some of the options may have expired out of the money.

These wouldhave created ordinary income or short term

capital gain for the seller.

Some of the options may have been exercised and

assigned to the sellermaking him short the stock.

He could eliminate the short position in either of three

ways: i) Deliver stock already owned outright, ii) Buy

stock to cover the short and sell appropriate LEAP calls

or iii) Exercise ESOs and deliver the stock to cover the

short stock. The third choice is the least attractive choice

because it forfeits “time premium” and causes early taxes.

Hedging Step 5.

In the next year, repeat the selling of the calls as in the

above steps, being conscious of the delta risks and the

erosion risk and the possible tax consequences. Perhaps the

employee is fully vested by now.

Hedging Step 6

In the next years do the same as in Step 5 until you find

yourself short calls equal to 60% - 70% of all vested options

(executives must be careful of SEC Rule 16- c, since some

claim that an executive can sell calls only to the extent of his

stock holdings). He should also be short calls equal to 60% to

100% of all stock owned. As time passes, the employee should

“roll back” his short calls. This means that as the now

“near term” short calls approach expiration and have very

little or no “time premium” remaining, he buys them back and

sells longer term LEAPs.

There is a larger incentive to roll back the listed calls when

there is a substantial short term capital or ordinary loss to

be taken.

Example of total LEAP positions through-out the life of ESOs.

Grant day: LEAPs short = 7% of ESO’s + 7% of long stk
Grant day+ 1 yr : LEAPs short = 14% of ESOs + 14% of long stk
Grant day+ 2 yrs: LEAPs short = 21% of ESOs + 21% of long stk
Grant day+ 3 yrs: LEAPs short = 28% of ESOs + 28% of long stk
Grant day+ 4 yrs: LEAPs short = 35% of ESOs + 35% of long stk
Grant day+ 5 yrs: LEAPs short = 42% of ESOs + 42% of long stk
Grant day+ 6 yrs: LEAPs short = 49% of ESOs + 49% of long stk
Grant day+ 7 yrs: LEAPs short = 56% of ESOs + 56% of long stk
Grant day+ 8 yrs: LEAPs short = 63% of ESOs + 63% of long stk
Grant day+ 9 yrs: LEAPs short = 70% of ESOs + 70% of long stk
Grant day+10 yrs:

All in–the-money ESOs must be exercised prior to

expiration day.

Liquidate the proper number of shorted listed calls and liquidate

stock received on exercise of the ESOs in a manner that

minimizes risk and taxes,while maximizing capital gains.

In the case where incentive stock options (ISOs) are held, tax

advantages can be achieved by holding the stock received

upon exercise for over one year from the exercise date.

In the case where ISOs are held, one may consider selling more

than 7% (perhaps 8-10%) annually of the ISOs held. If an

employee manages his ISOs properly, he can in fact increase his

after tax yield by over 40% on average relative to the

“premature" exercise’ strategies.

If the employee views the prospects of the employer more

positively, then just strategically sell fewer calls during his

time of bullishness.

If your view of the company's prospects are less positive,

then selling more Leaps earlier is suggested. Perhaps you

may sell as much as 15 % per year, instead of 7%, untill

the total reaches 65-70%.

This strategy accomplishes several objectives:

1.Reduces risks (delta and theta and vega).

2.Captures the time premium.

3.Reduces or eliminates taxes.

4.This strategy also preserves a limited bullish position

during the life of the options, thereby keeping the

employee’s interests aligned with the interests of the company.

5.This strategy recognizes that there is a high risk of

getting zero from your employee stock options.

This assures that you will get at least somthing.

In the case of Insiders (i.e. officers, directors, and owners

of 10% or greater of the company stock) special consideration

must be made to comply with SEC rules and company

restrictions. In certain circumstances, all or some parts

to the 7% solution may not be available to such officers.

Few people can carry out these strategies without training

by experts in trading and managing of listed options.

REAL LIFE EXAMPLE

Assumptions for EBAY Executive July 5, 2004.

1. Stock equals 91.00 (45 after the most recent split).
2. Options are granted to executive to purchase 10,000 shares@ 91
3. Options expire in 10 yrs. from grant date
4. 20% of the options vest per year
5. Early termination after vesting allows exercise within 90 days from termination.
6. Executive expects to be at company till he retires in ten years.
7. He owns 20,000 shares of stock outright and expects to receive more options grants in the future
8. There are some restrictions on hedging
9. He wants to reduce risks and reduce taxes
10. He is not concerned about how his hedging would be perceived
11. Executive has capital losses that he liquidated one year ago of $350,000.00

Recommended Trades

1. Immediately upon grant, the employee should sell 12 listed Jan 90, 2007 LEAP calls for a price of $2,290 each = $27,480.00
2. One year from grant, he should again sell 12 Jan 90, 2008 LEAP calls for market prices. Prices can not be determined until day of sale. Prices should sell near the theoretical values.
3. Two years from grant, sell 12 Jan 90, 2009 LEAP calls. Forty per cent of the employee options should be vested by now.
4. Three years from grant, sell 12 Jan 90, 2010 LEAP calls, looking for opportunities to take tax losses on earlier LEAP calls written.
5. Four years from grant sell 12 Jan 90, 2010 leap calls, while looking for opportunities to take tax loses and roll near term short positions in calls to longer expiration dates to avoid assignments.
6. Same approach as 5. All ESOs are vested, with 36% of the employee stock options and 18% of long stock covered by sales of listed LEAP calls
7. Same approach as 5 and 6. Sell 12 Jan at the money LEAP calls with expiration day of 2012
8. Same approach as 7, and continue until the executive is comfortable with risk and prospective gains. Do not make sales of LEAPs that make your short call positions greater than 65 against your ESOs to purchase 10,000 shares. Do not make sales of LEAPs that make your short call positions greater than 200 against the 20,000 shares long.
9. In the ninth and tenth years, try to reduce your positions unless you have been granted more employee options or more stock. If you are granted more options or stock, just start the process over again.

What we have done so far is to hold a bullish position in

Ebay stock and options. We have reduced the erosion

risks and delta risks of holding naked stock and options

from the initial day of grant. We have captured a large

portion of the “time premium” which is often forfeited

upon “premature exercises”. We will have delayed and

minimized the tax liability.

The exact details of what specific LEAP calls should be

sold and when to buy them back to achieve maximum

results can not be determined on day of grant but must

be delayed to the future.

Alternative Strategy if Hedging with Listed Options against

Employer Stock Options is Prohibited by contract.

A) Simply sell listed calls on 5-10 stocks that have high positive

correlation to the employer's stock. This may take a bit more

accounting but it may be the only way to efficiently hedge the

risks of holding the ESOs.

B) Since there is no restriction on selling positively correlated

stock short or options, there is no need to be concerned with

SEC or Company restrictions.

C) The only real problem in this method is that the 5-10 stocks

may not have a high tracking to the employer stock in fact.

Warning, these startegies can only be carried out efficienly

by expert options traders. There are only a handful of

optionsexperts who can help employees and executives in

these startegies

John Olagues olagues@hotmail.com  

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.