This Risk Matrix illustrates where the most risk is when holding employee stock options.. The risk is greater when the options are moderately in-themoney, not deep in-the-money as most book writers believe. http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

2. The following two slides illustrate why holding vested moderately in-the-money employee stock
options is more risky than holding deep in-the-money ESOs.
The third slide addresses how to reduce that risk.

3. Where is the Highest Risk when holding Employee Stock Options?
.
The Matrix below shows the “fair value” of employee stock options at various stock prices at different times to expiration. This
allows an examination of the changes in the ESOs value over times and the risks of holding the ESOs under different conditions.
Exer. Pr..Stock Pr...Volatility...Days to Ex...Fair Value….Time Value.
50………50.00............35...........1400.............14.01...............14.01 ….The color equations below show the % drops in the
50………56.25............35...........1400.............18.38...............12.13…...ESOs "fair value" with 25% drops in the stock.
50………75.00............35...........1400.............33.07 ………....8.07…..The largest % drops in the ESOs are with the options
50………93.75 ...........35............1400............49.48................5.75… that are moderately in-the-money compared to the
50…..…100.00............35............1400........... 55.21...............5.21 .......% drops in the deep in-the-money ESOs.
50….…. 125.00...........35............1400............78.73............... 3.73
50……..50.00............35............1000..............11.76...............11.76…….This is proof that when the stock is trading
50……..56.25............35............1000..............15.92................9.67……. at $100 with an exercise price of $50, the risk
50……..75.00............35............1000..............30.58................5.58 …… is less than when the stock was trading at $75.
50……..93.75............35............1000..............47.22................3.47…….The higher risk is from the higher volatility of the
50……100.00............35............1000..............53.03................3.03…..…options values and the much larger erosion of
50……125.00............35............1000.............76.93................1.93……. higher “time values” when the stock
is moderately above the exercise price
50……..50.00.............35............500................8.31................8.31 .......
50……..56.25.............35............500..............12.35................6.11……...33.07 to 12.35 = 20.72 = 63% drop
50……..75.00.............35............500...............27.42............... 2.47 ……..55.21 to 27.42 = 27.79 = 50% drop
50……..93.75.............35............500...............44.83................1.18………78.73 to 44.83 = 33.90 = 43% drop
50…….100.00............35............500...............50.97................0.97………
50…….125.00............35............500...............75.61................0.61
.

4. .
Exer. Pr....Stock Pr...Volatility...Days to Ex...Fair Value….Time Value.
50……......50.00.............35............500..............8.31................8.31………
50……......56.25.............35............500............ 12.35...............6.11………
50…..…....75.00.............35............500.............27.42............... 2.47 ………
50…..…....93.75.............35............500.............44.83................1.18……….
50…….....100.00............35............500.............50.97................0.97………
50…....….125.00............35............500.............75.61................0.61..........25 % stock drops over 400 days show greater
percentage losses for the ESOs with lower "intrinsic
values" as shown in the color graphs shown below
50…..…. ..50.00.............35............100............3.68....................3.68........
50……... ..56.25.............35............100.............7.82.................. 1.57........... 27.42 to 7.82 = 71.5% drop
50……... ..75.00.............35............100...........25.12........... .......0.12 ............50.97 to 25.12 = 50.7% drop
50……... ..93.75.............35............100...........43.83.......... ........0.07.............75.61 to 43.83 = 43.0% drop
50……....125.00............35......... ...100...........75.05........ ..... ....0.05
If different percentage drops of the stock were examined, (for example 30 35, or 40% drops), the results of the percentage drops
of the options would show greater percentage drops. If the drops occurred over longer periods, the percentage drops in the
options would be greater because of the greater erosion of the "time value".
This means that if fiduciaries are concerned with risk reduction, they are required to advise reducing risk when the ESOs are
most risky. And that occurs when the ESOs are moderately in-the-money. The strategy of early exercise, sell and diversify is
highly inappropriate when the ESOs are moderately in-the- money and is inappropriate except in rare situations. The
inappropriateness results from the required forfeiture of "time value" and the payment of an early tax and the questionable
benefits of "diversifying". That leaves only one choice to efficiently manage ESOs that are significant parts of the employees
assets. That is to sell calls or do other efficient risk reduction trades in the exchange traded options markets.

5. .
So in view of the information in the two slides above, how does a holder of moderately in-the-money ESOs,
(i.e. the stock is trading at $75 with a $50 exercise price) reduce the risk?
He/she simply opens a brokerage account and sells some calls perhaps 5 or 6 calls for every 1000 ESOs
that he has that are vested. Perhaps the ones with the exercise price of $80 or $85 with 9 months to 2 years
time remaining are the most appropriate. That would reduce his risk by about 35 % and he still has a
substantial alignment with the shareholders. If he/she sold more calls, the risks and alignment would both
be reduced further.
If he wanted protection against extreme downward moves, he/she could purchase a small number of puts,
perhaps in his IRA, and sell less calls.
This strategy assumes that there is no company prohibition by the company and that the ESO holder has
sufficient collateral to finance the call sales or the put purchases and that there is a reasonably liquid market
to make the options trades.
On the other hand if the company wanted to facilitate the reduction of risk to holders of moderately in-the-
money ESOs without hedging, they could design the options better. Check out the link below
http://www.slideshare.net/OLAslideshare/new-dynamicemployeestockoptionspresentati-4-12038997