There are many articles that contend that executives

are effectively prohibited from using exchange traded

listed options to hedge their employee stock options.

That alleged prohibition comes from either:

1. A contractual prohibition between the executive

and the employer or

2. Restrictions that relate to Securites and Exchange

Commission rules or

3. Constraints from tax rules or

4. Practical aspects of hedging with exchange

traded options.

The purpose of this article is to analyse whether

the above contraints indeed prohibit or make it

impractical to hedge.

1. Employer contractual prohibition

Certainly the employer and the executive can

enter an agreement whereby the executive

by contract can not hedge his ESOs with listed

options on the company stock. This contractual

prohibition is the exception rather than the rule.

Does that mean that he can not use listed

options to hedge his long company stock by

the use of listed call options? He can sell the

stock, so why would he be prohibited from

doing covered writes against the stock?

He is probably not.

Does the contractual prohibition mean he can

not write listed calls on his competitor's and

other positively correlated stock to reduce

his risk of holding his ESOs?

Certainly seems like he is not prohibited.

Although, the Options Agreement has to be

clearly understood before the executive does

any hedging, in most cases effective hedging

of some sort can be accomplished.

2. The Securities Act of 1934 section 16 b,

and c and SEC Rule c-4 and 10b5.

Section 16 b makes profits from short swing

trading recoverable to the company. 

This means if there is buying and selling of

company equity securities within six months of

each trade and a profit is made, then the

executive can have the profits recovered by the

company.

Hedging consistent with this rule can be

accomplished by writing LEAP calls.

If the stock increases substantially and causes

a loss in the writen options, the loss even if

taken within six months has no penalty to the

executive. He can not transfer the loss to the

company.

If the written calls decrease in value, he can

just wait out the six months before he closes

the position and takes a profit.

SEC Rule 16 c) prohibits the short sale of

company stock by officers, directors and holders

of more than 10% of the stock. The purpose of

the rule is to make sure an executive does

not prosper when his company's stock

goes down.

SEC Rule 16 c-4) extends 16 c) to selling calls and

buying puts on the company stock.

However, the executive is not prohibited from

writing calls or doing collars to the extent

that he owns the stock. But the question then

arises: What constitutes being long stock?

Is a synthetic long stock (i.e.long call and short put

with the same strikes and time to

expiration) considered long stock? Traders know

it is essentially the same. How about long the ESOs

and short a related put? Is that long stock? How

about vested long ESOs with very low strike prices?

The delta is 100. Looks like stock equivalent to me.

Assume the ESOs have a strike price of 20 with

the market price of the stock at 50.

If he writes calls with a 55 strike, will he be long

deltas? Yes, he would and his whole

position would lose value if the stock goes down.

It seems reasonable that here, he should be

allowed to write those calls against the highly

appreciated ESOs.

There is a letter from the SEC to Credit Swiss

dated March 18, 2004, which isdiscussed below.

www.sec.gov/divisions/corpfin/cf-noaction/csfb031804.htm

This letter is in responce to a request from

Credit Suisse First Boston to the SEC Division

of Corporate Finance to comment upon a

package of trades to be made between Credit

Suisse First Boston and executives holding

appreciated ESOs.

Essentially CSFB wants to accomodate executives

by having an interpretation of Rule 16c-4 that fits

their objectives.

The SEC says it has no problem as long as the

trades are executed as described in the letter.

The group of trades consist of a "collar" and a

sale of a put related to the substantially

in- the- money ESOs held by the executives.

The executive who was long substantially in

the -the - money ESOS would then be long what

traders refer to as a "verticle call spread" plus

long a "verticle put spread" where his delta and

other risks have been substantially reduced.

Some claim that this letter to Credit Suisse

opens the door to hedging by ESO holders

while not specifically long the stock without

violating Rule 16 c-4) as long as the hedge is

structured to the SEC's liking.

I personally have proposed to the SEC that they

should consider the total delta positions of equity

securities of an executive rather than using a

reference to 16c-4 for their decision to allow

hedging against ESOs. But, they claimed that

they were not prepared at this time to change

to a "delta" based perspective.

SEC Rule 10 b 5)

This is the rule that prohibits insider trading in

the company stock based on material non-public

information. The company and its officers are

obliged to take steps to prevent such trading

and in fact do so. This is why there are black- out

periods. Black out periods apply only during

sensitive periods and never apply to trading

positively correlated stock. Some executive create

Rule 10 b 5)-1 plans where they regularly sell long

stock and stock received from just exercised ESOs.

These executives, in my opinion, should create Rule

10 b 5)-1 plans to sell listed calls against their long

stock when they have long ESOs.

Tax Rules Restrictions:

Gains from NQESOs is compensation income

calculated as the difference between the stock price

and the exercise price on the date of exercise.

Gains on QESOs get long term capital treatment if the

stock is held more than one year after it is received

upon exercise of the options and qualifies.

When restricted stock become vested, its market

value becomes compensation income.

Gains or losses from "writing" calls by public traders

are generally considered short term capital gain or loss.

Gains or losses from hedges against NQESOs may

be considered as ordinary gain or loss pursuant to

Rev. Ruling 1.1221.

Can this rule be used to create tax shelter where

theoretical gains on the ESOs are delayed to the future?

Although it has never been adjudicated, a position

consisting of long ESOs versus short listed calls

should not be considered a straddle since there

is no "fair market value" of an ESOs and the value of

the option is uncertain.

However, some well regarded tax experts

claim that sales of listed calls versus ESOs do create

1092 Tax Straddles. 

 

Does anyone really claim that, if a holder of

ESOs writes calls on the competitors 

stock and other positively correlated stock, then

this is a "straddle" for tax purposes? I certainly

would not. 

 

Hedging with highly correlated listed stock options.

This is perhaps the best way for executives to

manage their ESOs. You will have to email

olagues@hotmail.com for this discussion.

John Olagues

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