Employee stock options

Index

Book Covers ...1
John's Picture...2
Bio...3
Objects of proper management of ESOs...4
Risks of holding Employee stock options...5
Avoid premature exercises...6
4 Graphs on ESO values with exercise results...7-12
Comparison Graphs with explanation... 13-15
Taxes explained....16
Constraints, Real and Imagined ....17

John Olagues Truth In Options 504-305-4449 www.optionsforemployees.com/articles John Olagues Truth In Options www.optionsforemployees.com .

Bio of John Olagues: Born in New Orleans and Attended Jesuit High School B.A. in Math Tulane University Captain of the Baseball Team All-SEC Pitcher Inducted into the Tulane Athletic Hall of Fame 2008 John was a pension consultant, an investment adviser and a stock broker. In 1976, he became an options market maker on the PSE in San Francisco and co-founded Options Research, the first service to offer theoretical options prices to market makers and the public. In 1980 he became a market maker member of the CBOE, the worlds largest Options floor. He probably traded more options in more diverse situations than any market maker who walked on the floor. Since 2003, John and his company Truth In Options has focused on applying hedging strategies that he created as a market maker to managing employee stock options. In 2009 John created with John Summa the only book on the subject. Getting Started in Employee Stock Options .

How to Manage Your
Employee Stock Options
Reduce Risk
Enhance Value
Delay and Reduce Taxes
Preserve Employee/Stockholders Alignment of Interests

Risks of Holding ESOs Visit the link below for an idea of the risks associated with holding ESOs un-hedged . http://www.hoadley.net/options/probgraphs.aspx On the day of grant, the probability of losing 100% of your options' "fair value" is about 35-60%, if held un-hedged until expiration.

Avoid Premature Exercises

Our First Rule of Managing your ESOs is to avoid premature exercises because the premature exercise

Forfeits the remaining "time premium" back to the company

Causes an early "compensation income tax" on the intrinsic value of the ESOs upon exercise, most of which is withheld on the exercise day.

Graphs in the following slides show

The "fair value" of ESOs as stock price changes

The changes in "time premium"over time

The changes in "Intrinsic value"

The results upon premature exercise.

Higher Volatility Assumed The following slide changes certain assumptions that were made in the previous three slides, although the exercise price and the dividend stay the same. The main change is the volatility which goes from .30 to .60 and overwhelms the assumptions of lower interest rates and less expected time to expiration. We can easily see the differences in time premium with the higher volatility.

Hedge your ESOs by

Selling listed Calls (out-of-the money)

Buying listed Puts (at-or-in-the-money)

Create small positions in the early years after the grant (even when un-vested). This choice is not available to section 16 executives

The next slide shows three Graphs which compare the results of selling 30 listed calls with a strike price of $450 versus ESOs to buy 3000 shares of Google stock at $350 with the stock at $416 to the results of holding the ESOs to expiration un-hedged.
The vertical axis shows the value of the combined positions at expiration.
The blue graph shows the result of holding the ESOs un-hedged to expiration.
The green graph shows the results at expiration of hedging by selling 30 calls (for $8300 each) with a strike price of $450. Both the ESOs and the calls expire in 20 months after the sale.
The red graph shows the results of selling the same 30 calls versus ESOs to buy 3000 shares where the ESOs expire 2 years after the calls expire. The difference between the red and green graphs represents the remaining time premium in the ESOs with two years to expiration. Although the graphs assume a sale of 30 calls versus 3000 ESOs, we seldom hedge beyond 60-70%
No taxes were considered in these graphs

Tax Treatment of Hedging ESOs is Friendly
IRS Section 1092 does not apply to hedging ESOs, in our view
Constructive Sale IRS Section 1259 is not an issue
Wash Sale Rule Section1091 IS not a constraint
"Loss harvesting" opportunities often arise
In our view, the concern for the mismatching of tax treatments where the possible capital losses on the sale of calls are matched versus the ordinary profits on the ESOs is overstated. This is so since the probability of such an event having a substantial impact is quite low and can be dealt with by selling fewer calls or buying a few puts in place of call sales.
IRS Section 1221 seems likely to apply to hedges versus non- qualified ESOs.

Other Constraints do not Deter effective Hedging.

Generally companies do not prohibit hedging
Generally companies do not allow transferability
Most stock plans do not allow pledging ESOs
Margin Rules are reasonable
SEC Rules and Securities Laws are reasonable
Tax Rules are friendly
Alignment of interests continue longer with hedging

www.optionsforemployees.com/articles

Employee stock options

by Truth In Options

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Employee stock options Presentation Transcript