Whenever I speak with a person who has experience with

employee stock options, I generally get the comment that

hedging defeats the object of the options grant.

The person claims that the purpose of granting ESOs is

to align the interest of the company with the

interests of the executives.The claim is that hedging

the ESOs essentially reduces the equity position of the

executive and that defeats the object of the grant

and it should be discouraged by the employer.

That idea is just another myth that pervades the ESO

industry.

Let's look at the idea closely.

We will do so by way of an example.

Many executives these days own stock to go along with their

employee stock options.

Assume that an executive owns 4000 shares and ESOs to

buy 10,000 shares with a expiration date of five years from

today.

The options are exercisable at $50 with the stock

trading at $70.

In traders lingo, the two combined positions may have a delta

of long 12,200 shares (i.e. +4000 from the stock and +8200

from the options). So here the executive could be perceived

as owning the stock equivalent of 12,200 shares.

a) If he were to sell the 4000 shares (whcih is not discouraged

by the company) he would reduce his deltas by 4000 shares

and thereby reduce his alignment by 4000 shares.

b) If he were to prematurely exercise ESOs to purchase 4000

shares and sell the stock, his deltas would be reduced by

perhaps 3280. This of course is not discouraged by the company

after vesting even though it will have reduced the executives

alignment with the company by 3280 stock equivalents.

c) If he were to sell his 4000 ESOs on some new transferable

options plan, his delta would be reduced by 3280, thereby

reducing his alignment accordingly.

d) If he were to sell (write) listed LEAP calls on 4000 shares of

stock with an exercise price of 75 against the 4000 shares,

this would reduce his deltas by perhaps 2400. His alignment

would be lessened by the 2400 deltas.

So why would the company discourage d) and not discourage

a), b) or c)?

In fact, discouraging d) reduces the value of the options in the

eyes of the executive/grantees. This reduction of value

requires a larger grant to executives to create the same

incentive. If the hedging was not discouraged, the executives

would perceive the ESOs to have more value,

thereby requiring less total options granted

and thereby less accounting costs to the employer.

In fact, if companies were to encourage a gradual hedging of

the ESOs from the date of grant to expiration, this would

create more value in the eyes of the executives and require

fewer grants and less expenses against earnings. This would

also provide the executive an efficient way to exit his options

positions, reduce risks and delay taxes.

It can be reasonably speculated that there are other factors

that come into play to explain the encouragement of early sales

of stock and premature exercising ESOs while at the same time

discouraging the hedging of ESOs with listed calls. It is not

however, to increase the alignment of the dual interests.

Those factors are a) the company gains a reduced liability

from premature exercises due to time premium forfeited back to

the company, b) the company gets a tax deduction

immediately upon premature exercise, and c) the company gets

an infusion of cash immediately. These factors are the real

reasons that the companies encourage premature exercises.

Selling of stock is encouraged less than the encouragement

of premature exercises. Discouraging hedging with listed

options is essentially encouraging premature exercises.

John Olagues

www.optionsforemployees.com