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How to Manage Your Employee Stock Options Grants

Its estimated that over 10 million employees, managers, officers and directors in the United States have been granted and still have employee stock options.

A large part of those were granted by companies that have exchange traded stocks and options.

Other than a very few of those 10 million, those grantees do not manage their grants efficiently. In fact very few understand the nature of the grants, the value of the grants, or the risk of losing that value.

There is only one way to manage those grants efficiently if the grantee wants to reduce risk, maximize the value of the employee stock options and reduce taxes. That way is to systematically hedge the granted options by predominantly selling (writing) exchange traded long dated calls.

For example:
Assume three years ago you were granted 1000 Apple computer employee stock options with an exercise price of $155  which are now vested. The present "fair value" of those 1000 ESOs is approximately $206,000 ($168,600 in intrinsic value + $37,400 of "time value")  with the stock trading at $323.6.

The best strategy by far is to sell 10 January 2013 calls with exercise price of $350 receiving $53,400 for ten calls. The sale of the calls will reduce 570 of the 850 deltas (equivalent stock positions) in the ESOs. However, the potential gain on the upside is substantially reduced. If the grantee wanted to reduce the risk of extreme moves he would buy some puts to replace some of the short calls.

The employee stock options advisers who call themselves "options experts" would not agree with my program choosing instead to recommend "premature exercise, sale of stock and diversify", which will result in loss of value of about $54,000 (the $37,400 in forfeited "time value" plus the penalty of the early tax payment)  on average when compared with hedging.

There are some incidental constraints to hedging. But the taxes are friendly and margin requirements are low. It is possible to  make the earnings from the employee options tax free.

The premature exercise strategies are highly beneficial to the company from recapture of "time value" and early cash flows from tax deductions and exercising the options.

So In conclusion:

The employee should not make premature exercises in situations similar to the above unless he absolutely needs the money or has no other choice. Advisors who promote premature exercises in situations as above are negligent and are subject to liability from such negligence. They are essentially advising a strategy that benefits the company to the detriment of the employee/grantee.

John Olagues

P.S. I will be happy to demonstrate  the specifics benefits of hedging to any holder of employee who may be thinking of early exercise, sale and diversify. Just send me the details by email at olagues@gmail and I will give you a free analysis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.