Gives a comparison of hedging using exchange traded options with premature exercises John Olagues www.truthinoptions.net olagues@gmail.com 504-875-4825 http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

1. For ESO Holders and their Advisers...
June 10, 2010, 2010
On Oct 5, 2009. I sent the email newsletter below:
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Comparing Hedging ESOs with Premature Exercising,
Selling and Diversifying.
Example:
Suppose four years ago you were granted ESOs to buy
3000 Apple Computer shares at $90 per share, along
with a grant of 800 Shares of Restricted stock. Both
are now vested and the Restricted Stock is fully paid
for. Today's market price of AAPL is 185. The ESOs
have a maximum time remaining to expiration of 6
years.
The "fair value" of the ESOs using a .40 volatility and
a 2 percent interest rate is $111 per ESOs or
$333,000. The value of the 800 shares is $148,000.
The Grantee has three choices:
ONE. Hold the position and hope for the best,

2. accepting the very real risk that he may lose most of
the value if Apple goes back down and trades in the
mid 80s as it did in March 2009.
TWO. Exercise the ESOs, sell the 3000 shares of stock
and diversify the residual after tax amounts.
THREE. Hedge the stock and ESOs by selling calls and
buying puts.
Lets examine choices TWO and THREE.
CHOICE TWO...If he exercises the 3000 ESOs and
sells the stock, he will get net after tax $171,000 not
counting state tax if any, social security tax, and
expected tax increases from Obama. He takes the
$171,000 and then buys a diversfied ETF.
CHOICE THREE...Assume he sells 40 calls with a strike
price of $250 expiring in January 2012 for $25.20
each or $100,700 in total. He then buys 4 Jan 2012
puts with a strike price of 190 at $44.65. There should
be no margin calls if he deposits the 800 shares into
his account.
Below I will Illustrate that regardless of what the stock
does in almost all cases, hedging far out performs the
net after tax results from strategy TWO.
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3. -----
Assume various prices of Apple stock when the calls
and puts expire.
Apple Stock Values * P and L P and L ESO Values Value of ESOs +
Price on of ETF on calls on Puts 3 yrs. expected call and put profit.
Jan 2012 time to expiration
Expiration
130 $145,000 +$100,700 +$ 6,200 $171,000 $ 277.900
190 $173,000 +$100,700 -$17,800 $330,000 $ 412,900
240 $197,000 +$100,700 - $17,800 $474,000 $ 556,700
277 $213,750 - $8,000 - $17,800 $582,000 $ 556,000
No taxes were considered for these calculations. The
800 shares ware not part of the above calculations.
* The Value of ETF is an estimated value of the ETF
with the different Apple Computer stock prices
** These hedged positions are substantially bullish
positions. Had we sold a few more calls, our bullish
positions could have been reduced, thereby reducing
the mutual alignment with the company. The
alignment would still be more than what remained
after the exercise sell and diversify strategy.
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Summary:
In almost every case, the results are far better than
the premature exercises, sell and diversify strategy
even if you exercise the ESOs on the day that the calls

4. and puts expired. Of course we would rarely exercise
ESOs with 3 years to expiration.
Rather than making a premature exercise with three
years to expiration, we would hedge with new long-
term calls and puts in the same manner, thereby even
further widening the gap again. The advantage of
hedging versus premature exercising to me is so clear
that one should wonder why advisers who call
themselves experts ignore a strategy that offers far
greater results with less risks.
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On November 29, 2009 we looked at an up-date
as below:
Now lets see how we could be doing with the
preceding comparison.
1) Last price of AAPL on 11/29/09 was $200.59, up
$15.59 or 8.4 percent since Oct 5. The increase on
the 800 shares is + $12,472
2) The Jan 2012 calls with an exercise price of $250
were trading about $29.25 up 4 points from the time
of sale of 40 calls at $25.25.The result would be -
$16,000

5. 3) The Jan 2012 puts with an exercise price of $190
were down from $44.65 to $37.30 or a loss of $7.35
points or -$2940.
4) The employee stock options have advanced in "fair
value" by $14.80 or +$44,400
Totals from the hedging strategy is the following:
Calls sold = -$16,000
Puts bought = - $2,940
Gain on ESOs +$ 44,400
Net total gain = + $25,460 gain from the hedging
strategy
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The Standards and poor index is up from 1054 to
1091 or up 3.5 percent. The $171,000 would therefore
be
equal to $171,000 x 1.035 = $176,985.
Net total Gain = + $5,985 gain from the diversified
portfolio
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6. Of course the 800 shares have made a profit of
$12,472 for each position
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The losses on the 40 calls and the 4 puts could be
harvested and other calls (perhaps 35 of the Jan
$280s) sold and puts (perhaps 12 of the Jan $210s)
bought. The Wash Sale Rule would not apply. In my
view IRS section 1092 would not apply to the sale of
40 calls and the purchase of the 4 puts versus the 800
shares and the 3000 ESOs.
The loss on 8 calls would be capital loss since they
were “qualified covered calls” and the rest of the
losses would be either capital losses or ordinary losses
depending on whether IRS Section 1221 applies. All
liquidated losses are reported currently.
These losses could be applied to other capital gains
the employee may have had during 2009 and after
that to ordinary income at a rate of $3000 per year.
So with the hedging strategy in 7 weeks we see a net
gain in value of $25,460 with total reportable current
losses of $18,940.
This result is far superior to the strategy of premature
exercise, sale and diversify which here resulted in just
a $5,985 gain and no tax savings.

7. And the hedging strategy maintained a greater
alignment of interests with the stockholders.
We suggested an adjustment to add some positive
deltas and to "harvest losses".
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January 28, 2010 update
Now we will do an additional short comparison of the
results of our hedging with the strategy of premature
exercise, sell, and diversify as mentioned above.
Apple is trading at $199.30 which is down $1.20 from
November 29, 2009 or up 14 points from the time we
began the hedge on October 5, 2009.
The 40 Jan 250 calls are down $3.5 points at $25.75
from its value on November 29, 2009 , the ESOs are
down about 1 point and the puts are down about $3.
Mainly as a result of time erosion and a slight
reduction in implied volatility and a slight drop in the
stock.
There is a gain from November 29, 2009 on the
hedging positions combined and a loss on the
premature exercise and sell strategy as the S&P index
is down .6%

8. The gain from November 29,2009 is + $14,000 from
the 40 calls short but a loss on the ESOs of about
$3600 in theoretical value. There is a loss on the 4
puts of about $3 giving a loss of $1200. So the
summed total on the hedging positions is a gain of
$9400 compared with a loss on the diversified
portfolio of the S&P index of $1000 or a difference of
$10,400.
However if the suggestion to make the adjustment on
November 29, 2009 was executed then there would a
decrease of about $3400 in value from the $9400 to
$6000 making the difference of the two strategies just
$7000 in favor of hedging since November 29, 2009.
The delta of the hedged positions have increased as
the value of the short calls have lost value from
erosion and a decrease in implied volatility. Therefore
we suggest the purchase of a put vertical spread
selling the losing puts and recording a loss on the
previously purchased puts . If the puts are purchased
in an IRA, that makes for a larger negative after tax
delta than if purchased outside of the IRA.
The result of the comparison is that the total value of
the hedged position have increased $9400 (or $6000)
since November 29, 2009 but the diversified positions
have lost $1000, further illustrating the advantages of
hedging.

9. This gives the holder of ESOs an idea of the
superiority of hedging over the strategy of premature
exercises, sale and diversify.
John Olagues
Olagues@gmail.com
http://www.optionsforemployees.com/articles
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