The purpose of this article is to prove that hedging ESOs

by selling listed call options and sometimes buying puts

is tax friendly. We will do so by giving an example with

Amazon Stock:

AMZN stock closed on September 6, 2007 at $86.21.

Suppose that 1 year earlier a grantee received ESOs to

buy 200 shares of stock at 60, when the stock was

trading at 60.

The 200 ESOs now have a theoretical value (i.e. intrinsic

value plus time premium) of $4720 x 2 = $9440 today

September 6, 2007.

The January 2010 listed calls with a strike price of 100

and the current price at $86.21 were trading at about

$1770-1790 per call at the close.

Suppose the grantee sold 2 of the Jan 2010, 100 calls at

$1770 each or $3540 in total as a hedge against his/her

200 ESOs. There is no tax on the sale proceeds at the

time of sale.

If the stock increases substantially, there is an

unliquidated loss on the calls sold, off-set by the

theoretical gains on the ESOs.

The result is that there should be a net combined gain as

the stock goes up because the positive deltas from the

ESOs are greater than the negative deltas from the calls

sold.

If the calls were bought back with the stock at 150, and

the straddle rule of IRS section 1092 does not apply, the

grantee may take and report a capital loss on the calls of 

 - $9200 after 5 months (or perhaps -$7700 after 17 months).

He does not report any gains on the increased value of

the ESOs because they will not be exercised for years

into the future.

He can deduct the loss against ordinary income ($3000

per year maximum) over three years unless he already

has other capital losses that are being used for the same

reason.

On the other hand, the gains on the short calls when the

stock goes down or stays the same or increases slightly

can be delayed to expiration of the listed calls (or longer).

If they are out of the money at expiration there is a short

term capital gain on expiration day.

If the short calls are in the money at expiration then the

capital gain or loss is delayed untill when the grantee

liquidates the short stock position.

For example: if the stock closes at 105 on expiration day,

the calls that were sold for $1770 each are worth just

$500 each. But since they are exercised by the call buyer,

the seller does not have to report a gain on the $1270

profit on each call untill he covers the short position

in the stock.

He can stay short the stock forever and delay the $3540

gain on the 2 calls sold. If the stock then goes lower he

can stay short and never liquidate his profit, although he

can receive the profit. Because of how margin accounts

work, he would be able to get the profits without covering

the short stock.

If the stock advances after the assignment of the exercise,

the un-liquidated gain is eliminated by the rise and there

may be a capital loss that can be taken if the stock

advances further.

 
Sale of Jan 2010 80s

If the grantee chose to sell the 2010 calls with an 80 strike

price rather than the 100 strike, he would be closer to delta

neutral. This means that the combined loss on the down side

would be small and the combined gain on the upside would be

small. But selling the 80s makes it easier to harvest tax losses

and defer gains because the probability of getting assigned

the 80 calls is greater. This will allow a greater probability of

delaying prospective gains and early liquidating of  prospective

losses.

Buying Puts to Hedge:

If long term puts are bought to hedge ESOs, there is the

chance that the gain can become long term capital gain

if the puts are held for over one year prior to being sold

or exercised and covered. 

Using IRAs to hedge:

If a grantee has a Roth IRA or a Traditional IRA with

sufficient assets and the investments are discretionary, the

grantee can buy puts and sell call verticals to hedge his

long stock positions. He could also buy bearish put verticals

as an effective hedge.

Since the Straddle Rule would apply against stock and the gains

in an IRA are tax free or tax deferred, this presents some

interesting opportunities. If the stock goes substantially higher

after hedging in a IRA, the loss in the IRA when taken will

increase the cost basis of the stock. If the hedge creates a

profit inside of the IRA, that profit when liquidated is tax

free if sold prior to the liquidation of any offsetting position.

Summary

So selling calls and buying puts is tax friendly regardless

of how the stock moves, whatever calls are sold,

or puts are bought, to hedge.

Those denying that selling calls as a hedge is tax friendly are

merely doing the bidding of the wealth managers and the

company itself, both who want premature exercises. There

are many arguments made to discourage hedging, most of

which are exaggerations.

Essentially, the financial and wealth managers do not

sufficiently understand options and what can be done

to reduce risk, preserve the options value and reduce taxes.

Nor do they want to get involved in using a hedging strategy.

So they use the naive strategy of making premature

exercises, selling the stock and diversifying the after

tax residual amounts, which often costs the client half

his options value.

John Olagues