Risks of Holding Employee Stock Options.

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Illustartes the Risks of holding Employee Stock Options. Those risk are the delta risk and theta risks and the only way to reduce the risks efficiently is to sell calls and to a lesser degree buy …

Illustartes the Risks of holding Employee Stock Options. Those risk are the delta risk and theta risks and the only way to reduce the risks efficiently is to sell calls and to a lesser degree buy puts.

How to manage grants of Employee Stock Options to reduce risk, minimize taxes and enhance value seems to be a subject that most participants in the Employee Stock Options arena avoid like the plague.

Although many think that they have support in a paper called "Optimal Exercise of Employee Stock Options and Securities Arbitrations" by Craig McCann and Kaye Thomas 2005 to promote the strategy of exercise early, sell the stock and "diversify", it can be proven that that strategy is highly inefficient in all but rare situations.

That strategy is worse than doing nothing as there are large penalties associated with the strategy that diversifying can never overcome and it avoids risk reduction where the risk is the highest.

The reliance on that strategy promotes the interests of the employer/company and the wealth managers at the expense of the grantee/employee.

Would your organization be interested in publishing article on those topics by true experts?

John Olagues
olagues@gmail.com
http://www.wiley.com/WileyCDA/WileyTitle/productCd-

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  • 1. . Calculating the Risks of Holding Employee Stock Options
  • 2. .There are two substantial risks to holding employee stock options that thispresentation will focus on.1. The Delta Risk...the chance that the stock will go down thereby reducing the"fair value" of the options by a percentage of the drop of the stock within a shortperiod of time. If an ESO has a .50 delta, the option is expected to drop 50cents for a one dollar drop in the stock.2. The Theta Risk... the chance that the "time value" will erode over time.These two risks will change as time passes and the stock has decreased orincreased.For example the delta will increase from perhaps .55 to.65 if the stock goesfrom $100 to $110. On the other hand if the stock goes from $100 to $90, thedelta may have dropped to .43. Time passing gives more delta to ESOs that arein-the-money and less delta to ESOs that are out-of-the-money ESOs.
  • 3. .Lets assume that you were granted 1000 ESOs on a stock trading at $50.The delta at grant day may have been .62, with the "time value" equal to $22,000.Three years later when those options vest, the stock is trading at $75 and the delta(or equivalent stock position) is now .85.The "time value" may have dropped to $10,000, with $25,000 of "intrinsic value" fora total value of $35,000.If the stock remained near $75 at expiration day, the $10,000 time value" is lost. Ifthe stock was 20% lower from $75 (i.e. $60), the "time value is lost" and the"intrinsic value has dropped to $10,000. So the $35,000 of value decreased to$10,000 or down 70% from when the stock was $75.
  • 4. .The position where the stock was $75 after vesting is highly risky and fiduciariesare required to try to reduce risk. Holders of ESOs are faced with this situation 3times as often as they are faced with the situation of the stock trading at near $110.But no one seems to be interested in how to reduce risk when the stock is 50%above the strike after vesting. Why? The only method is to sell calls or buy puts in away that efficiently reduces delta and erosion risks.There are some rare cases where that method is prohibited by the stock plans andsometimes the employee does not have the necessary funds to initiate the trades.But that strategy requires the wealth managers to perform way above their abilities.So they promote early exercise, sell and "diversify".