Early Exercises of ESOs Worse than Early Withdrawal from 401 K Plan

There are many "Options Advisors" and "Options Experts" who claim competence in the ESOs arena.

Most offer some form of advice that consists of early exercising of the ESOs, sale of part or all of the stock received and diversify the residual net proceeds after compensation taxes.

This advice is very similar to advice to liquidate your 401 k Plan at age 50.

Lets compare the two:

Assume that a employee has $258,000 in a 401 K plan and he also holds 1000 Google vested ESOs with 5 years of expected life, exercisable at 300.

Google (GOOG) stock was trading at 470 on May 4, 2007.

The theoretical value of those ESOs was $258,000 ( i. e. $170,000 of intrinsic value plus $88,000 of time premium).

If the 50 year old participant in his 401k plan withdraws all of the money, he will owe $25,800 in a penalty and income tax of perhaps 40% on the $258,000). So he nets after tax and penalties about $129,000 out of $258,000 value.

On the other hand, if an optionee exercises his ESOs, he forfeits all of the remaining time premium of $88,000 back to the company and pays perhaps 40% income tax on the remaining $170,000, netting him after tax an amount $102,000.

Why would an advisor tell the employee to make the early exercise knowing that the consequences are worse that a early withdrawal from a 401 k plan?

The answer lies in the fact that advisors are doing the bidding of the companies and are taking care of themselves by generating commissions and getting assets under management.

They claim that they are reducing risk and there is no other way to do it. The same argument can be advanced via-a-vis the 401 K Plan.

However in the case of the ESOs, effective hedging with call options can be made, whereas hedging against the assets in the 401 K Plan can not be done as easily.

Comments

[patrick.che...:]

Three problems with this. First, any hedging plan of similar duration would either be very expensive (buying puts) or very impractical (selling calls) if only because it would require a great deal of margin. (Keeping in mind that any in-the-money position in the ESO itself cannot be used for margin). Second, an owner of substantial options may be a director or higher - which could create a conflict when trading. Third, recent history from 2001 teaches us that it is easy to get pinched out of an in-the-money position when the market moves quickly against you. For those who don't have large margin accounts and are not sophisticated traders, their only hedge is to take part of the position off the table.

2007 May 11 06:03 AM

[John O:]

Patrick:

Thanks for your comment

I will try to address the issues you raised.

1. The initial Minimum Margin Requirement for selling (writing) 10 "naked" listed calls

with an exercise price of 520 expiring in Jan 2009 was, prior to April of this year, 10%

of the value of the stock at 470 (i.e. $47,000.00). Ten calls of course gives the buyer

the right to buy 1000 shares. The Market price of the options was about $66,000 for

the 10 calls.

So if you had no Google stock you would have had to put up $47,000.

The recent rules changes make the minimum initial requirement about $40,000.

If you owned 100 shares fully paid for in the account, there may be only

$10,000 of margin requirement.

Of course if the 401 k plan was self directed, the employee could merely sell the calls

here and pledge enough of the assets to cover the margin. He should sell perhaps

five or six calls because of special tax treatments of gains in a 401 K plan.

2. Buying puts can be usefull at times, but we generally think selling calls is better.

3. If the holder is a director or officer, he can hedge with no problem as long as he

complies with SEC Rule 10b-5 and Rule 16c-4 and Section 16b of the 1934 Act, which

is quite easy to comply with if he has good advisors.

We always maintain a long delta position so if there is a large up move requiring an

ajustment for margin purposes, it comes after the value of the combined positions

has increased.

The idea is to avoid costly premature exercises, reduce risk and delay taxes. The

same principles apply to considerations of removing money from a retirement plan.

John

2007 May 11 10:58 AM