Assume that an employee was granted 1000 ESOs on

Google four years ago when the stock was trading at

$300.00.

When the stock went to $650 in 2007, the intrinsic

value of the ESOs was $350,000. Our optionee became

worried that insiders were selling billions of dollars of

Google and that they were disguising the true cost

of executive and employee options grants. He knew

that if Google counted all of the actual compensation

to their employees by way of options grants as a hit

against earnings, they had very little earnings at all.

He decided to buy 10 LEAP puts with an exercise price

of 750 and expiring in fourteen months, paying

perhaps $140 per put option (i.e. 100 of intrinsic value

and 40 points of time premium). He would have to pay

approximately $140,000 to hedge much of the delta risk

in the ESOs.

He could have bought the puts on margin of 75 percent.


Let's analyze the transaction:

A) First of all, was he prohibited by contract with Google

from hedging? I could find nothing in Google's Stock Plan or 

Awards agreement that prohibits hedging. So he was ok there.

B) Did the IRS Section 1092 Straddle Rule apply? Upon further

analysis, the Straddle Rule did not apply. But there is a good

likelihood that Section 1221 would apply and that the offsetting

positions would be considered a "hedging transaction". If this

was indeed the case, then the Section 1092 could not apply

and any liquidated gains or losses would be ordinary when closed.
 

C) Did the Constructive Sale Rule apply. He believed it

did not apply here because he still had a potential profit if the

stock advanced substantially higher. Buying the risk reducing

puts was not the sale of "substantially identical" security

as the ESOs.  He also understood that if the stock did not

move substantially up or down, he would have his time

premium in the ESOs and in the puts eroded over time.

So there was still potential gain and potential loss.

Therefore, there are no Constructive Sale worries.

D) Were there SEC prohibitions of what he did. Since he

was not an officer or director, no worries again. He had

no inside information so there was no concern for

violations of  SEC Rule 10 b-5.

E) So now Google was trading at 433 on Feb 8, 2008. He

still held the ESOs and the puts. The puts have increased

from $140,000 to $317,000 (i.e. with no time premium

remaining in the puts), making a profit of $177,000. The positions

together are now slightly bearish (i.e the negative deltas from

the puts are greater than the positive deltas from the ESOs).

If he sold the puts and IRS Section 1221 applied, then the gain

or loss would be ordinary income. If Section 1221 did not apply

his gain would be long term or short term capital gain depending

on how long he held the puts. Since he was trying to hold the

puts for a year, he decided to wait for another two months when

the puts would have been held for over a year.

He could, if he wished, exercise the puts and be short the

stock, where his tax on the profit would be delayed

indefinitely. But he would have to hold margin in his

account to hold the short position. If he wished to

even deltas (i.e. create a neutral equivalent stock position),

he could have exercised the puts and bought some calls

without incurring a taxable event. He could take back his

original investment and most of his profits on the puts

upon exercise if he simultaneously bought calls versus

the now short stock to even his deltas or have positive

deltas when the still existing ESOs are considered.

Of course if he had bought some of his puts in an IRA,

he would be able to sell those puts with the profit

coming to his IRA tax deferred or tax free regardless

of the length of time that the puts were held.

F) The theoretical value of the ESOs would now be

$133,000 of intrinsic value plus the time premium of about

$50,000 totaling $183,000.

Had our grantee not hedged with puts or any other way and

exercised his ESOs and sold the stock at 650,

he would have netted $350,000 x .60 = $210,000.

The net after tax gain would be greater with the put hedge.

He would have had a $177,000, gain that is not taxable

currently and still have the ESOs valued at $183,000.


Hedge versus stock

If instead of holding ESOs, our hedger held long stock,

he could have accomplished a good tax result.

For example: assume that the hedger bought 200 shares of

Google at 300 which was trading at 650 in 2007. Assume

he bought 2 of the same puts with an exercise price of 750 in

his IRA. The two positions are considered a straddle making

it such that if he has a loss on the puts, that loss would

increase the cost basis of the stock, assuming he designated

the offsetting positions as an "identified straddle."

But if he had a gain on the puts, that gain is tax deferred or

tax free, assuming the puts were sold prior to the sale of the

stock .

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Now, much of the substance of this article will be disputed

by some wealth managers.

But in almost every case, except where the grantee

needs the money and has no other choice, hedging

with ESOs exchange traded calls and puts is a far better

choice than making premature exercises' selling the stock

and diversifying. The diversifying idea is overrated.

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