How to reduce the risk in holding traditional employee stock options
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How to reduce the risk in holding traditional employee stock options

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Employee stock options have a value when granted and until they expire. That value increases as the stock increases in value. This presentation explains why early exercise, sell stock and......

Employee stock options have a value when granted and until they expire. That value increases as the stock increases in value. This presentation explains why early exercise, sell stock and "diversified" is worthless, when risk reduction is considered. Top executives hold their ESOs to near expiration and never make early exercises since they understand the penalties of doing so. To reduce risk and taxes sell calls or buy puts. Its the only efficient way.

www.truthinoptions.net
www.qqoption.com

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  • 1. How toReduce the risk of holdingEmployee Stock Options Efficiently
  • 2. If you own a substantial amount of vested employee stock options andwant to reduce risk of holding appreciated ESOs, there is only oneefficient way to do it. That is to sell (i.e. write) exchanged traded callsand perhaps buy a number of puts when the ESOs are most risky.Making early exercises, selling the stock and “diversify” has largepenalties and is essentially a bet against the company and a bet on thebroad market (i.e. if you diversify into the S&P 500 for example). Thoselarge penalties are in the form of forfeited “time value” and thepenalties of paying an early tax. The only time it is justified is whenthere is little or no “time value” and ex-dividend day approaches.However, no major wealth managers advise efficient risk reductionbecause that strategy raises the costs to the company/employer anddelays cash flows to the company. Efficient management of ESOs bythe employee also delays and perhaps reduces future Assets UnderManagement to the wealth managers.I know of no organization in the equity compensation arena thatpromotes efficient management of vested ESOs. In fact theydeliberately promote the highly penalized early exercise, sell anddiversify strategy. Why? They are certainly not promoting the interestsof the employees. Do they not understand what they are doing? I thinkthey know that they are choosing to help the company and the wealthmanagers at the expense of the employees.Below illustrates the large penalties of early exercises to theemployees which benefits the employer accordingly.
  • 3. Penalties of Early Exercising ESOs and Selling Stock outweigh any merits of Diversifying. This slide shows the total penalties to the employee(red) for early exercises of 1000 ESOs with a .30 Volatility, 5% risk free Interest rate, "0" dividend, and exercise price of $20Exer...Market...Vol...Expected….Time……Early......Total.....Net..AfterPrice….Price Time.to …..Value …..Tax Tax…………………………..Expiration..Forfeited..Penalty..Penalty….Proceeds20...........30........30......5.5 yrs.....$6114....$1200.....$7314.......$600020...........40........30......4.5 yrs.....$4528....$1918.....$6418......$12,00020...........50........30......3.5 yrs.....$3368...$2100.....$5578......$18,00020...........60........30......2.5 yrs.....$2372....$2000.....$4372…...$24,000-------------------------------------------------------------------------------------- Below are the penalties of early exercise of 1000 ESOs with a much higher volatility of .60, a 3% risk free interest rate, "0" dividend20..........30.........60......5.3 yrs.....$9300....$1200...$10,500......$600020..........40.........60......4.3 yrs.....$6460....$1918.....$8378......$12,00020..........50.........60......3.3 yrs.....$4740....$2100.....$6840......$18,00020..........60.........60......2.3 yrs.....$2870....$2000…..$4870......$24,000
  • 4. The above slide illustrates that the penalties of early exercise are quitelarge even when the stock is “deep in-the-money”. This contradicts thebasic theory of most advisers that through “diversifying”after exercisingESOs and selling stock will increase returns with less risk.See the Paper of Craig McCann and Kaye Thomas “Optimal Exercise ofEmployee Stock Options and Securities Arbitrations” in 2005 whichpromotes the early exercise strategy.This is why the most noted CEOs in the U.S. practically wait untill daysor weeks before expiration to exercise and sell.Below are some examples of noted CEOs exercising their employeestock options.Lloyd Blankfein CEO of Goldman SachsLloyd Blankfein exercised 68,800 on 11/26-28/2012 expired 11/30/12Lloyd Blankfein, exercised 90,681 on 8/11/2010 expired 11/26/10James Dimon CEO of J.P. MorganJames Dimon exercised 462,000 on 3/2/2012 ESOs expired 4/16/12James Dimon exercised 1,261,000 on 7/17/09, ESOs expiring 8/15/09
  • 5. John Chambers CEO of CiscoJohn Chambers of exercised 2,000,000 on 2/8/10, ESOs expiring 5/14/10John Chambers exercised 1,350,000 on 2/13/07, ESOs expiring 5/1/07Larry Ellison CEO of OracleLarry Ellison exercised 10,000,000 on 4/3/09, ESOs expiration 6/4/9Steve Jobs CEO of AppleSteve Jobs exercised 120,000 on 8/12/07, ESOs expired 8/13/07Tim Cook CEO of AppleTim Cook exercised 200,000 on 3/24/ 2012 ESOs expiring 3/24/12Paul Otellini of IntelPaul Otellini exercised 800,000 on 11/9/07, ESOs expired 11/12/07Sam Palmisano CEO of IBMSam Palmisano, exercised 300,000 on 8/1/11, ESOs expiring 2/25/12Rex Tilleson CEO of Exxon MobilRex Tillerson exercised 197,300 on 2/23/11 expired 11/28/11
  • 6. Now why would these executives, who can pay for the best advice, waituntil almost expiration of the employee stock options to make theexercises? They have ignored the advice that is given by wealth managersand stock brokers to the great majority of employees holding substantialamounts of ESOs. That advice is to make early exercises when the stock istrading about 110% above the exercise price after vesting. That advice ispromoted by the industry and allied organizations. In some cases advisershave been sued for not giving such advise if the stock has subsequentlydropped substantially. See the Paper of Craig McCann and Kaye Thomas “OptimalExercise of Employee Stock Options and Securities Arbitrations” in 2005.John OlaguesOlagues@gmail.com504-875-4825 or 504-333-4065