Selling covered calls against employee stock options extends alignments (1)


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This presentation explains one of the myths about optimal management of your employee stock options

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Selling covered calls against employee stock options extends alignments (1)

  1. 1. . Selling Calls against Employee Stock Options Extends Alignments Does Selling Exchange Traded Calls to Generate Income and Reduce the Highest Risks of Holding Employee Stock Options Extend the Purpose of the Options Grant? Whenever I speak with a person who has some experience with employee stock options, I generally get the comment that hedging by selling calls defeats the object of the options grant. The person claims that the purpose of granting ESOs is to align the interest of the company with the interests of the executives. The claim is that hedging the ESOs essentially reduces the equity position of the executive and that defeats the object of the grant and it should be discouraged or prohibited by the employer. That idea is just another myth that pervades the Employee Stock Options industry.
  2. 2. . Lets look at the idea closely.: We will do so by way of an example. Many executives these days own stock along with their employee stock options. Assume that an executive owns 4000 shares and ESOs to buy 10,000 shares with an expected expiration date of five years from today. The options are exercisable at $50 with the stock trading at $75 (a highly risk position) In traders lingo, the two combined positions may have a delta of long 12,700 shares (i.e. +4000 from the stock and +8700 from the options). So here the executive could be perceived as owning the stock equivalent of 12,700 shares. If he were to a) sell the 4000 shares (which is not discouraged by the company) he would reduce his deltas by 4000 shares and thereby reduce his alignment by 4000 shares. If he were to b) prematurely exercise ESOs to purchase 4000 shares and sell the stock received, his deltas would be reduced by perhaps 3480. This of course is not discouraged by the company after vesting even though it will have reduced the executives alignment with the company by 3480 stock equivalents. If he were to c) sell his 4000 ESOs on some new transferable options plan, his delta would be reduced by 3480, thereby reducing his alignment accordingly.
  3. 3. . This type of transferable option was introduced by Google at the encouragement of Morgan Stanley. If he were to d) sell (write) listed LEAP calls on 4000 shares of stock with an exercise price of 80 against the 4000 shares, this would reduce his deltas by perhaps 2400. His alignment would be lessened by the 2400 deltas. So why would the company discourage or prohibit d) and not discourage a), b) or c), because a), b), and c) all reduce the alignment more that d). Some companies actually try to use their Insider Trading Policy to prohibit the sale of calls, when there is no prohibition in the Stock Plan contract document or the grant agreement contract. They do so in order to make early exercises of ESOs the only way to reduce the risk of holding substantially in-the-money ESOs. Their true purpose is to create the early cash flows and reduce the company’s liability to their employees, and thereby creating earlier Assets Under Management for the wealth managers. In fact, discouraging d) reduces the value of the options in the eyes of the informed executive/grantees. This reduction of value requires a larger grant to executives to create the same incentive. If the call selling was not discouraged, the executives would perceive the ESOs to have more value, thereby requiring less total options granted.
  4. 4. . In fact, if companies were to encourage a gradual call selling of the ESOs from the date of vesting to expiration day, this would create more value in the eyes of the executives and require fewer grants and less expenses against earnings. This would also provide the executive an efficient way to exit his options positions, reduce risks and delay taxes. John Olagues 504-875-4825