Some advisors claim that one easy way to reduce the risks

of holding Employee Stock Options is to buy listed puts

on the employer's stock. They claim that the margin

requirements are low, the costs are pre-determined,

there will never be a margin call or an unwanted early

assignment of written calls. And most of the upside

potential can be preserved.

They claim, considering everything, that buying puts is

superior to selling calls to reduce risks of holding ESOs.

Lets compare buying puts to selling calls.

Understanding Risks

In order to understand how to best reduce the risks of

holding employee stock options, an employee must

first understand what those risks are.

1. First, there is the risk that the employer stock may

drop thereby causing the theoretical value (since

there is no market value) of the employee stock

options to drop. We call this the delta risk.

2. Then there is the risk that, over time, the options'

"time premium" wears away by erosion. This is called

the theta risk.

3. There is also the risk that the implied volatility of the

options or the recent historical volatility of the stock

may drop causing a loss of theoretical values.

Some call this the vega risk.

4. There is the risk of lower interest rates and higher

expected dividends, which also lowers the theoretical

values of ESOs.

5. There is also the risk of the employee/executive

terminating prior to expiration and losing all or part of

the value of the employee stock options.

Hedging with listed options can not reduce this risk.

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So how do we reduce the risks, outlined in 1,2,3,4 above,

most effectively? Selling calls with short or longer

durations reduces the delta risk and the theta risk.

Selling longer calls also reduces the risk of decreasing

volatility, decreasing interests rates and higher

dividends.

Buying puts becomes an effective hedge only if there

is an expected substantial drop in the value of the stock.

This is true unless the puts are substantially in the money

when bought. How much of a drop is necessary to

achieve an effective hedge of ESOs depends on the

strike price of the listed put purchased.

Buying puts adds erosion of time premium (the theta risk)

to the already eroding time premium in the ESOs.

Buying puts adds to the risk of loss from declining

volatility (the vega risk), which is already there in the ESOs.

Of course if volatility goes up, its better to own puts

because the added volatility adds theoretical value

to both calls and puts.

When all the increases in risk associated with buying

puts are calculated, it becomes apparent that buying puts

against holding long term employee stock options often

increases more risks than it reduces.

Buying puts can be useful if the employee wishes only

to hedge against a large downward move in the stock

until the puts expire. If there is just a small amount

of time premium in the ESOs remaining, a grantee may

wish to buy in the money puts as part of a hedge strategy.

There are also situations where buying in the money puts

together with selling overpriced puts can provide an

effective hedge.This is called "buying a put vertical spread."

However, this requires expert advisers who are generally

not available. Holding speculative ESOs is risky. Adding

a long position in speculative puts, while giving profits in

the event of substantial downside moves, adds speculative risk

on balance.

Margin Requirements

Regarding margin requirement considerations:

In many cases, selling naked calls requires less margin

than buying naked puts. The minimum margin on selling

naked calls is a low as 10% of the value of the stock

on out-of-the-money calls. This compares favorably

to the costs of puts. However, many brokerage firms

discourage selling naked calls and charge excess margin

over the required SRO minimums. Margin advanced for

naked call selling plus the proceeds of the call sales are

credited to your margin account immediately and generally

earn interest.

If the seller of calls owns stock, his sales of listed

options are considered covered to the extent of

his long stock. He receives the proceeds immediately

to do as he pleases with no current taxes or interest

payments.

When theoretical values are considered, generally

the sales of calls are superior to the purchase of out

of the money puts. Why this is so is beyond

the scope of this article.

If the grantee wished to use his IRA for hedging

against his ESOs, buying puts or buying put

verticals may be the only strategy available. 

John Olagues