Got Employee Stock Options? Grok's rule for when to exercise

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Postby grok87 » Sat Mar 06, 2010 1:12 pm

Strikeout wrote:To: Wagner and Grok.

The vast majority of employee stock options have no intrinsic value (i.e. exercise prices that are either greater than the present market prices) or have an intrinsic value less than 65% of the exercise price.

The great majority of employee stock options are on stocks that are reasonably volatile and have little or no dividend.

The great majority of existing employee stock options are less than 8 years old, especially if you exclude those held by CEOs to near expiration.

Given the above, why do you guys focus on employee stock options that are in the vast minority.

The vast majority of existing ESOs are candidates for hedging strategies if the holders are interested in reducing risk and enhancing their value with lower taxes (I do exclude those that are held by officers and directors that are at or out of the money, where the executive holds no stock).

The strategy of premature exercise , sell stock, and diversify has merit in only very few cases and is far inferior to efficient hedging strategies in most cases. And those are where the stocks have little or no time premium remaining. But all of the ESOs which now have little or no time premium, once did have substantial time premium which was entirely at substantial risk.

So what is the purpose of focusing on a small majority of cases when the great majority gets ignored?

JO

John,
It's a good point. I for one think that hedging could be a valuable tool. It's nice to have an option expert (negative theta? I must have been absent that day from CFA class!) such as yourself posting on this topic.

But I agree with Andy that your example is not what we need. Here's what I think we need- I'll illustrate with an example:

Say an employee is granted 1000 options at 20 for 10 years. 5 years later the stock is at 30. It would be nice to be able to hedge to accomplish the following objectives:

1) Lock in the $10,000 intrinsic value
2) At the cost of giving up some, but not all upside from the stock.
3) Say you would get some fraction (50%? 70%?) of future upside beyond $30 per share for the next 5 year period.

Got anything in your toolkit that would accomplish that?

Or do we have to buy the book?
http://www.optionsforemployees.com/

:)
cheers,
grok, CFA | Danon delenda est
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Postby Wagnerjb » Sat Mar 06, 2010 1:35 pm

Strikeout wrote:
The vast majority of employee stock options have no intrinsic value (i.e. exercise prices that are either greater than the present market prices)


OK, but we don't care about these.

or have an intrinsic value less than 65% of the exercise price.


We don't care about these either, since they are not deep enough in the money to present a diversification issue.

The great majority of employee stock options are on stocks that are reasonably volatile and have little or no dividend.


I gave you four real-life examples of companies. These are typical of the kind of company I work for. Maybe more stock options are granted at more volatile companies, but I can only speak for the kinds of companies that I see every day, that my friends and colleagues work for, etc.

The great majority of existing employee stock options are less than 8 years old, especially if you exclude those held by CEOs to near expiration.


Sure, but we don't care about them when they have 1 year left to expiration, since exercise is the superior strategy at that point. We do care about the few instances when they are deep in the money and have 8 years to go.

If you worked for DuPont and got options in 1995, the stock price was twice the grant price within 2 years. If you got DuPont stock options in 1996, the stock price was twice the grant price within 2 years. If you worked for Chevron and got options in 2003, the stock price was twice the grant price within 2 years. If you worked for Valero and got options in 2004, the stock price was 6 times the grant price within 2 years.
These are real-world issues we are dealing with.


JO - with all due respect, the covered call strategy that you are suggesting is a) impossible for 8 year options, b) illegal or highly inappropriate at many companies, and c) ineffective at heding the real risk being discussed.

Grok and I are indeed focused on a minority of stock options. For the vast majority of situations, holding until expiration is the superior strategy. For the minority of situations where the options are deep in the money, have plenty of time left, and are a significant portion of your net worth.....this is the issue that requires a risk mitigation strategy, and we have discussed two sensible alternatives....his formula and the guidelines that I linked.

Best wishes.
Andy
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Re: Comparison of hedging with exercise and diversify

Postby Strikeout » Sat Mar 06, 2010 3:17 pm

grok87 wrote:
Wagnerjb wrote:
Strikeout wrote:The only time premature exercise, sale and diversifying gets the better

results is if the individual stock performs far worse than the index.

JO


JO: but that's exactly what we are trying to hedge against. If the stock price plunges to $95, the stock options expire worthless. Sure, you got small gains but you didn't hedge very effectively.

If we assume other scenarios of the stock movements, the results are generally superior to the premature exercise , sell and diversify strategy.


I disagree. The framework that I prefer (not the more conservative rule that Grok prefers) would have the individual sell some - but not all - of these options. If the price surges another $100 to $300, you might find that the partial exercise scenario is superior to your covered call strategy.

The bottom line is that you are proposing a covered call strategy, which is not necessarily suited for an options diversification problem. The covered call strategy sells a little upside, while leaving the downside unprotected. That isn't what we need here.

Best wishes.

Agree


Let me ask a few questions of you two.

Have you ever hedged a position in stock or other options? Or have you ever traded calls or puts for any reason?

What do you think is the probability, at the time of the grant, of some ESOs being worthless at expiration assuming the ESOs are issued by the average issuer with average volatilities?

Let me also state that highly respected academics from NYU, Berkely /Haas Business School, Johns Hopkins, and others all agree that efficient hedging ESOs increase their value to the grantees and increases the cost to the companies. So who are you promoting?

I can also state without reservation that efficient hedging will reduce risk and increase the value of the ESOs and present opportunities to lower your taxes., starting from the day they are granted.

JO
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Re: Comparison of hedging with exercise and diversify

Postby grok87 » Sat Mar 06, 2010 4:03 pm

Strikeout wrote:
grok87 wrote:
Wagnerjb wrote:
Strikeout wrote:The only time premature exercise, sale and diversifying gets the better

results is if the individual stock performs far worse than the index.

JO


JO: but that's exactly what we are trying to hedge against. If the stock price plunges to $95, the stock options expire worthless. Sure, you got small gains but you didn't hedge very effectively.

If we assume other scenarios of the stock movements, the results are generally superior to the premature exercise , sell and diversify strategy.


I disagree. The framework that I prefer (not the more conservative rule that Grok prefers) would have the individual sell some - but not all - of these options. If the price surges another $100 to $300, you might find that the partial exercise scenario is superior to your covered call strategy.

The bottom line is that you are proposing a covered call strategy, which is not necessarily suited for an options diversification problem. The covered call strategy sells a little upside, while leaving the downside unprotected. That isn't what we need here.

Best wishes.

Agree


Let me ask a few questions of you two.

Have you ever hedged a position in stock or other options? Or have you ever traded calls or puts for any reason?

What do you think is the probability, at the time of the grant, of some ESOs being worthless at expiration assuming the ESOs are issued by the average issuer with average volatilities?

Let me also state that highly respected academics from NYU, Berkely /Haas Business School, Johns Hopkins, and others all agree that efficient hedging ESOs increase their value to the grantees and increases the cost to the companies. So who are you promoting?

I can also state without reservation that efficient hedging will reduce risk and increase the value of the ESOs and present opportunities to lower your taxes., starting from the day they are granted.

JO

John,
I'm not disagreeing that hedging could be a valuable tool. You were kind enough to give one approach- selling call options that are a bit out of the money. As WagnerJB and I posted above, I don't think that is what we need here. It fails to protect against the main risk, which is that the intrinsic value of the employer stock options goes to 0 (think Enron, Lehman, AIG and any other number of big respectable companies that have cratered or gone bankrupt).
I think the hedging strategy that we need is something like what I posted above. The ability to lock in the value of the "intrinsic value" of the options at a given point in time at the cost of giving up some but not all of the future upside. I'm sure there is probably an elegant options solution. I plan to play around with this a bit myself, but perhaps with your experience trading options and your forthcoming book you have already worked out the solution? Inquiring minds want to know!
:)
cheers,
grok, CFA | Danon delenda est
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Re: Comparison of hedging with exercise and diversify

Postby Wagnerjb » Sat Mar 06, 2010 4:40 pm

Strikeout wrote: Let me also state that highly respected academics from NYU, Berkely /Haas Business School, Johns Hopkins, and others all agree that efficient hedging ESOs increase their value to the grantees and increases the cost to the companies. So who are you promoting?



John: I am not sure what your question is. I have an MBA in finance from the University of Chicago. And I agree that hedging ESOs would add value. But only if you can do it properly.

Have you ever hedged a position in stock or other options? Or have you ever traded calls or puts for any reason?


I work in the energy trading department of a large oil company and I have discussed deep in-the-money ESOs with some of our professional options traders (who also have ESOs). They have confirmed what is obvious.....that selling puts is the only way to properly hedge ESOs.

Once you reach this realization, you face three issues:

a) Is it legal or appropriate to sell puts on my company stock?

b) If so, then is it feasible to sell puts on my company stock (are LEAPs available and actively traded)?

c) If it is feasible (short time until expiration), is selling puts superior to simply exercising....some or all of the options?

Best wishes.
Andy
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ESOs with intrinsic value also have time premium

Postby Strikeout » Sat Mar 06, 2010 11:05 pm

I am going to answer my questions.

The probability of the average ESOs, just granted, finishing out-of-the-money at expiration goes from about 35% to 55%. So there is a high risk of losing all of it grant value.

If the stock increases, it picks up intrinsic value and loses some of the time premium. Selling calls to hedge is more appropriate when there is substantial time premium as the sale of the calls "captures" time premium, thereby offsetting the erosion in the ESOs.

Buying puts to hedge adds to the time premium "erosion" but does work better when there are large moves in the stock up or down. If you fear an extreme move, buy a few more puts than otherwise.

When the ESOs's time premium is modest, it is probably best to sell some calls and buy a few puts (perhaps 3 or 4 calls sold for every one put bought).

When there is just small time premium remaining, it may be better to sell 3 calls and buy 2 puts.

I advise partial hedging always maintain substantially longs deltas to maintain the employee/ stock holder alignment.

JO.

Continued....
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Postby grok87 » Sun Mar 07, 2010 1:16 am

grok87 wrote:
Strikeout wrote:To: Wagner and Grok.

The vast majority of employee stock options have no intrinsic value (i.e. exercise prices that are either greater than the present market prices) or have an intrinsic value less than 65% of the exercise price.

The great majority of employee stock options are on stocks that are reasonably volatile and have little or no dividend.

The great majority of existing employee stock options are less than 8 years old, especially if you exclude those held by CEOs to near expiration.

Given the above, why do you guys focus on employee stock options that are in the vast minority.

The vast majority of existing ESOs are candidates for hedging strategies if the holders are interested in reducing risk and enhancing their value with lower taxes (I do exclude those that are held by officers and directors that are at or out of the money, where the executive holds no stock).

The strategy of premature exercise , sell stock, and diversify has merit in only very few cases and is far inferior to efficient hedging strategies in most cases. And those are where the stocks have little or no time premium remaining. But all of the ESOs which now have little or no time premium, once did have substantial time premium which was entirely at substantial risk.

So what is the purpose of focusing on a small majority of cases when the great majority gets ignored?

JO

John,
It's a good point. I for one think that hedging could be a valuable tool. It's nice to have an option expert (negative theta? I must have been absent that day from CFA class!) such as yourself posting on this topic.

But I agree with Andy that your example is not what we need. Here's what I think we need- I'll illustrate with an example:

Say an employee is granted 1000 options at 20 for 10 years. 5 years later the stock is at 30. It would be nice to be able to hedge to accomplish the following objectives:

1) Lock in the $10,000 intrinsic value
2) At the cost of giving up some, but not all upside from the stock.
3) Say you would get some fraction (50%? 70%?) of future upside beyond $30 per share for the next 5 year period.

Got anything in your toolkit that would accomplish that?

Or do we have to buy the book?
http://www.optionsforemployees.com/

:)
cheers,


OK here's the solution to the example I posed above:

1) Buy 10 put contracts (covering 1000 shares) @ 30- say cost is $7 a share
2) Sell 10 put contracts (covering 1000 shares) @ 20- say you get $4 a share
3) Sell 3 call contracts (covering 300 shares) @ 30- calls are worth $10 a share from put/call parity (see below)

THe net cash outlay from 1), 2), 3) is zero. You pay: $7,000 less $4,000 less $3,000 = 0.

Here's how the original employer stock options plus the options in 1), 2), and 3) payoff for various final stock price outcomes (figures in $000):

Final Stock....ESO....BuyPutAt30....SellPutAt20.....SellCallAt30......Net
15................0..............15.................-5..................0................10
20................0..............10..................0..................0................10
25................5...............5...................0..................0................10
30...............10..............0...................0..................0................10
35...............15..............0...................0.................-1.5.............13.5
40...............20..............0...................0.................-3................17

So basically this accomplishes the objective of locking in the $10,000 gain at the cost of giving up some (30%) of the future upside.

Now these numbers are made up- I'll have to work through a real example using BRK-B stock (which does not pay dividends). For a dividend paying stock paying around 2.3% (i.e. same as the 5 year interest rate) then the at the money put and at the money call would have the same price (in theory). That would mean you would have to sell more at the money calls (step 3 above) and would give up more upside in exchange for locking in the $10,000 intrinsic value.

Here's the put-call parity stuff:
Put-Call Parity (assuming no dividends)- X=strike, i=interest rate, T=time to expiration

Stock + Put(X) = Call(X) + X/(1+i)^T

for at the money puts S=X=30

$30 + $7 = Call +30/(1+i)^5

Assume 1/(1+i)^5 = 0.9 (about right for right now)

Call = 30 + 7 - 27 = 10

cheers,
grok, CFA | Danon delenda est
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Postby Strikeout » Sun Mar 07, 2010 10:49 pm

You can link link to Peter Hoadley's options site where you can go to determine the probabilities of the stock being above or below any percentage gain or any percentage decline sometime in the months or years into the future.

Most people ,who really understand stock options, understand the relative accuracy of his calculations. Although I traded as an options market maker for ten years, I did not understand his calculations until I had quit as a market maker.

Of course rare events do happen, with the stocks sometimes increasing or dropping dramatically in short periods of time.

If I were advising a person who has 1000 ESOs on a stock with an exercise price of 20 and the stock was trading at 30. I would tell him to sell about 7 or 8 calls with an exercise price of 35 with two years until expiration.

Granted the calls represent just a partial hedge. But there are a lot of reasons for that.

It reduces some risk and avoids forfeiture of the time premium and presents a possible advantage for taxes if the stock goes up.

If the executive with the 1000 ESOs is an officer or director and sells 10 calls and buys 5 puts and does not have an additional 500 shares long, he is in violation of SEC Rules, even if the calls are out of the money and the puts are out of the money. Those rules do not apply to employees who are not officers and directors.

JO
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Postby grok87 » Sun Mar 07, 2010 11:48 pm

strikeout wrote:If the executive with the 1000 ESOs is an officer or director and sells 10 calls and buys 5 puts and does not have an additional 500 shares long, he is in violation of SEC Rules, even if the calls are out of the money and the puts are out of the money. Those rules do not apply to employees who are not officers and directors.

JO

Thanks John, that's very helpful information. So is the idea that this officer/director can't (as per SEC rules) have a net "short" position in his company's stock. i.e.

1000 ESOs (long 1000 shares)
sell 10 calls (short 1000 shares)
buy 5 puts (short 500 shares)
---------------------------
= net short 500 shares which is not allowed
so you need to buy 500 additional shares of stock to balance it out and get to a net "neutral" position. Is that it?

strikeout wrote: If I were advising a person who has 1000 ESOs on a stock with an exercise price of 20 and the stock was trading at 30. I would tell him to sell about 7 or 8 calls with an exercise price of 35 with two years until expiration.

Granted the calls represent just a partial hedge. But there are a lot of reasons for that.

It reduces some risk and avoids forfeiture of the time premium and presents a possible advantage for taxes if the stock goes up.

I guess I'm still having some fundamental troubles understanding why you prefer this sort of hedging strategy:

1) It gives up 70-80% of the upside beyond $35 a share
2) It doesn't protect the $10,000 of intrinsic value (beyond the option premium that you get)

As WagnerJB and I have pointed out, isn't it better to buy puts to protect the intrinsic value and then perhaps sell some calls to pay for the puts? Assuming one is not restricted by SEC rules, or company rules from doing so?
cheers,
grok, CFA | Danon delenda est
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Postby Strikeout » Mon Mar 08, 2010 12:07 am

No you don't buy the 500 shares because that makes you longer deltas and the officer or director is trying to cut down on delta risk.

He has to stay away from the purchase of the puts unless he already has the shares. However, the officer or director can sell slightly out of the money calls and buy puts but has to sell other puts which complete the synthetic long stock position with the substantially in the money ESOs..

So the simplest thing to do for executives who have no stock but do have substantially in the money ESOs is just to sell long term slightly out of the money calls and maintain a positive delta (upside bias).

He may want to add negative deltas by buying put vertical spreads. He may buy the put vertical spreads in his self directed IRA and get even better results, everything considered.

JO
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Postby grok87 » Mon Mar 08, 2010 12:13 am

grok87 wrote:
grok87 wrote:
Strikeout wrote:To: Wagner and Grok.

The vast majority of employee stock options have no intrinsic value (i.e. exercise prices that are either greater than the present market prices) or have an intrinsic value less than 65% of the exercise price.

The great majority of employee stock options are on stocks that are reasonably volatile and have little or no dividend.

The great majority of existing employee stock options are less than 8 years old, especially if you exclude those held by CEOs to near expiration.

Given the above, why do you guys focus on employee stock options that are in the vast minority.

The vast majority of existing ESOs are candidates for hedging strategies if the holders are interested in reducing risk and enhancing their value with lower taxes (I do exclude those that are held by officers and directors that are at or out of the money, where the executive holds no stock).

The strategy of premature exercise , sell stock, and diversify has merit in only very few cases and is far inferior to efficient hedging strategies in most cases. And those are where the stocks have little or no time premium remaining. But all of the ESOs which now have little or no time premium, once did have substantial time premium which was entirely at substantial risk.

So what is the purpose of focusing on a small majority of cases when the great majority gets ignored?

JO

John,
It's a good point. I for one think that hedging could be a valuable tool. It's nice to have an option expert (negative theta? I must have been absent that day from CFA class!) such as yourself posting on this topic.

But I agree with Andy that your example is not what we need. Here's what I think we need- I'll illustrate with an example:

Say an employee is granted 1000 options at 20 for 10 years. 5 years later the stock is at 30. It would be nice to be able to hedge to accomplish the following objectives:

1) Lock in the $10,000 intrinsic value
2) At the cost of giving up some, but not all upside from the stock.
3) Say you would get some fraction (50%? 70%?) of future upside beyond $30 per share for the next 5 year period.

Got anything in your toolkit that would accomplish that?

Or do we have to buy the book?
http://www.optionsforemployees.com/

:)
cheers,


OK here's the solution to the example I posed above:

1) Buy 10 put contracts (covering 1000 shares) @ 30- say cost is $7 a share
2) Sell 10 put contracts (covering 1000 shares) @ 20- say you get $4 a share
3) Sell 3 call contracts (covering 300 shares) @ 30- calls are worth $10 a share from put/call parity (see below)

THe net cash outlay from 1), 2), 3) is zero. You pay: $7,000 less $4,000 less $3,000 = 0.

Here's how the original employer stock options plus the options in 1), 2), and 3) payoff for various final stock price outcomes (figures in $000):

Final Stock....ESO....BuyPutAt30....SellPutAt20.....SellCallAt30......Net
15................0..............15.................-5..................0................10
20................0..............10..................0..................0................10
25................5...............5...................0..................0................10
30...............10..............0...................0..................0................10
35...............15..............0...................0.................-1.5.............13.5
40...............20..............0...................0.................-3................17

So basically this accomplishes the objective of locking in the $10,000 gain at the cost of giving up some (30%) of the future upside.

Now these numbers are made up- I'll have to work through a real example using BRK-B stock (which does not pay dividends). For a dividend paying stock paying around 2.3% (i.e. same as the 5 year interest rate) then the at the money put and at the money call would have the same price (in theory). That would mean you would have to sell more at the money calls (step 3 above) and would give up more upside in exchange for locking in the $10,000 intrinsic value.

Here's the put-call parity stuff:
Put-Call Parity (assuming no dividends)- X=strike, i=interest rate, T=time to expiration

Stock + Put(X) = Call(X) + X/(1+i)^T

for at the money puts S=X=30

$30 + $7 = Call +30/(1+i)^5

Assume 1/(1+i)^5 = 0.9 (about right for right now)

Call = 30 + 7 - 27 = 10

cheers,

Ok I found a live example where the Stock price is trading at a dollar level where longer term puts and calls are available.

Oracle (ORCL)

current stock price =$25
assume 1000 ESOs with strike price =$15
1 year 10 months till expiration (Jan 12)

http://finance.yahoo.com/q/op?s=ORCL&m=2012-01

Oracle
Stock price = $25
Jan 12 puts@ $25 = $3.75 (mid bid ask)
Jan 12 puts@ $15 = $0.60
Jan 12 calls@ $25 = $3.62

So the steps would be:
1) Buy 10 put contracts (covering 1000 shares) @ $25- cost is $3.75 a share
2) Sell 10 put contracts (covering 1000 shares) @ 15- you get $0.60 a share
3) Sell 8.7 call contracts (covering 8700 shares, of course you can't do this exactly) @ 30- you get 3.62 a share.

Net cost = 1000*3.75 - 1000*0.6 - 870 *3.62 =0

so with 1 year 10 months to go, you would lock in your $10,000 of upside and still get the upside of 130 shares of stock over the next 1 year and 10 months.

The question is whether this is preferable to just exercising all the options and reinvesting the net after tax proceeds in say the Total Stock Market index. That's not so clear- probably need another post to think that through.

cheers,
grok, CFA | Danon delenda est
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Postby Wagnerjb » Mon Mar 08, 2010 12:45 am

grok87 wrote:The question is whether this is preferable to just exercising all the options and reinvesting the net after tax proceeds in say the Total Stock Market index. That's not so clear- probably need another post to think that through.

cheers,


If the dollar value of the options was material to your net worth, exercising (after over 8 years) would be the best alternative.

Did you notice that none of the three Jan. 2012 options that you cited actually traded on Friday? Zero volume. Sure, you only need 10 contracts, but you may have to bid up the price to entice sellers (and vice versa).

Best wishes.
Andy
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Postby grok87 » Mon Mar 08, 2010 12:49 am

Wagnerjb wrote:
grok87 wrote:The question is whether this is preferable to just exercising all the options and reinvesting the net after tax proceeds in say the Total Stock Market index. That's not so clear- probably need another post to think that through.

cheers,


If the dollar value of the options was material to your net worth, exercising (after over 8 years) would be the best alternative.

Did you notice that none of the three Jan. 2012 options that you cited actually traded on Friday? Zero volume. Sure, you only need 10 contracts, but you may have to bid up the price to entice sellers (and vice versa).

Best wishes.

Good points.
grok, CFA | Danon delenda est
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Postby Wagnerjb » Mon Mar 08, 2010 10:55 am

grok87 wrote:Ok I found a live example where the Stock price is trading at a dollar level where longer term puts and calls are available.

Oracle (ORCL)

current stock price =$25
assume 1000 ESOs with strike price =$15
1 year 10 months till expiration (Jan 12)



Grok: even if we ignore all the real-world issues that make hedging impossible, illegal, impractical and unnecessary....your example isn't one that we would be seriously considering for hedging. The example shows Oracle has appreciated 67% over 8 years, which is a very ordinary 6.6% annual appreciation rate. That's pretty typical stuff for a company, and isn't likely to make anybody hugely rich or badly undiversified.

That's exactly the kind of appreciation a company expects when they grant an option. And they set the number of shares based on this expected appreciation. For example, they may want to give a manager a bonus with a value of $30,000. The back into the number of stock options based on the expected value of these options....given a reasonable growth rate. If the company stock appreciates as expected, your options become worth $30,000 and you get the kind of compensation the company expects.....not a huge windfall. Bottom line - the Oracle facts won't drive somebody to a hedging issue.

Look at Chevron. Say you got 1000 stock options at $35, and today the stock price is $75 (still not a very extreme example). Your hedging example disintegrates in this case:

Buy 10 put contracts at $75. These cost $11.80
Sell 10 put contracts at $35. These don't trade, but the $45 contracts go for $1.51, so let's guess $0.50 for the $35 puts.
Sell 17 call contracts at $75. These cost $6.70

This leaves you with the "cashless" hedge that you want. But you sold too many calls, leaving you short rather than long. As you can see, this doesn't work in real life.


As I step back and think about this, the Chevron example makes sense. When your stock price has risen dramatically, you would expect more risk on the downside than the upside. Thus, the "at the money" puts are more valuable than the "at the money" calls. This is exactly what we see with Chevron. Guess which kind of employee is most likely to want to hedge? You got it.....the guy whose stock price has just risen dramatically.

Very interesting academic exercise, but sadly it just isn't something that real people can use with their employee stock options.

Best wishes.
Andy
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Postby dtcrisp » Mon Mar 08, 2010 2:24 pm

Is it legal or appropriate to sell puts on my company stock?


This is all a fascinating theoretical discussion, but for the typical *employee* with incentive stock options, selling puts on the company stock is a firing offense.

The theoretical discussion about collaring your stock applies more to someone who sold or left a company and retains shares.

For an actual employee, whether it be from the glory days of m$ or goog or whoever, the relevant question is the OP -- how do you decide when to exercise and/or sell.

Every one of these wild successes was a black swan. It's silly to blanket decree "sell as soon as you can". Few folks who held ISOs at these companies had any idea they would increase so much in value.

To the folks in this personal situation, make your own intuitive judgement of the likelihood of success, the upside and downside.
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My NQ stock option exercise policy

Postby bdavidson » Mon Mar 08, 2010 4:19 pm

I decided a while ago that I only wanted to get out of my options the initial value of the options when they were granted (i.e. grant price x shares). Then I would reinvest the proceeds in a total market index (probably International since it's going to be in a taxable account after the exercise).

I have 2 thresholds at which I will exercise:

1. Less than 1 year until expiration: options are at least 2x the grant price, recognizing the initial "compensation value" of the grant, but pay ordinary income taxes on that amount and realize less than the initial grant value.

2. Any time before expiration: the price reaches x + (x/(1-y)) where x is the grant price and y is my combined marginal tax rate (i.e. fed, state, medicare; SocSec gets maxed out each year regardless of options income, so I exclude it from the calc). So if my marginal tax bracket is 25% and the options were granted at $10, I would sell when the options are priced at 2.45x the grant price, or $24.50, and after taxes, I would net the $20 per share value of the initial grant.

This is a very simplistic approach, but I wanted to avoid a lot of the technical analysis going on in this interesting thread. I've read "The Diversification of Employee Stock Options" by Stein and Siegel that Andy recommended, but still found it to require too much thinking for how involved I wanted to be in the options.
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Postby Wagnerjb » Mon Mar 08, 2010 4:44 pm

dtcrisp wrote:The theoretical discussion about collaring your stock applies more to someone who sold or left a company and retains shares.



Even for him, it is a theoretical exercise if he cannot collar the option in a cashless collar like Grok showed. Here is another real-world case:

DuPont is selling for $35
You got options at $20

Buy 10 put contracts at $35. These cost $5.90
Sell 10 put contracts at $20. These sell for $1.34
Sell 12 call contracts at $35. These sell for $3.88

Again....like with Chevron, you cannot do a cashless collar. If you try, you end up short the stock.

In the real world of hedging, this former employee has to wait until his options have less than 2 years to expiration. Then he can lock in his $35 price (his current gain) but he must pay a cash price to do so. He does this by purchasing puts. Using this hedge method will eliminate his downside but keep the upside. But as we have been saying all along, once you get to the 2-year mark you gotta think seriously about just exercising some (but not all) options as the superior risk mitigation strategy.

Best wishes.
Andy
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Re: My NQ stock option exercise policy

Postby grok87 » Mon Mar 08, 2010 10:56 pm

bdavidson wrote:I decided a while ago that I only wanted to get out of my options the initial value of the options when they were granted (i.e. grant price x shares). Then I would reinvest the proceeds in a total market index (probably International since it's going to be in a taxable account after the exercise).

I have 2 thresholds at which I will exercise:

1. Less than 1 year until expiration: options are at least 2x the grant price, recognizing the initial "compensation value" of the grant, but pay ordinary income taxes on that amount and realize less than the initial grant value.

2. Any time before expiration: the price reaches x + (x/(1-y)) where x is the grant price and y is my combined marginal tax rate (i.e. fed, state, medicare; SocSec gets maxed out each year regardless of options income, so I exclude it from the calc). So if my marginal tax bracket is 25% and the options were granted at $10, I would sell when the options are priced at 2.45x the grant price, or $24.50, and after taxes, I would net the $20 per share value of the initial grant.

This is a very simplistic approach, but I wanted to avoid a lot of the technical analysis going on in this interesting thread. I've read "The Diversification of Employee Stock Options" by Stein and Siegel that Andy recommended, but still found it to require too much thinking for how involved I wanted to be in the options.

Hi bdavidson,
It's an interesting approach. One thing I would point out. You're saying you would not exercise if 1 year and 1 day to expiry if the stock was 2.4x the strike price (given the example you posted above). But you would then exercise the next day (once you get to 1 year and less) since then the 2.4 would be greater than your new 2x the strike price hurdle.
Nothing wrong with that approach but might be a little sudden in terms of the change in risk tolerance. A more gradualistic approach might improve things a bit.

The basic idea behind my rule is to look a the ratio of the time value of the options (approximately X*i*T for deep in the money options) and the intrinsic value of the options (S-X). This ratio is:

p=

Time Value
------------ =
Intrinsic Value

X*i*T
----------
(S-X)

= i*T/(S/X-1)

For example at T=1 year when S/X=2 or

p= 0.34%*1/(2-1) = 0.34% (since as per bloomberg the 1 year treasury is at 0.34%)
So similar to your rule, my rule would say you want to hold very little of your options at this point, only let the intrinsic value be 0.34%, i.e. basically 0.

Now let's look at the same math when you are 2 years from expiration:

p = 0.88%*2/(2-1)=1.76%. So this would say that you should have about 5x as much tolerance for holding these options when they are 2 years from expiration compared to 1 year from expiration. But the 1.76% is still a pretty small portion of your portfolio.

Now let's look at 5 years out

p = 2.36%*5/(2-1) = 11.8% of your portfolio.
At this point you are well above normal tolerance for employer stock (normally I would say don't hold more than 5% of your portfolio in employer stock). The reason is that there is a lot of time premium in the options at this stage and you don't want to throw that away without getting a lot of compensation from the intrinsic value.

So I guess my point is, if you assume the stock stays at 2x the strike price over the last 5 years till option expiration, I think you should gradually reduce the options from about 12% of your portfolio at T=5 to about 0% at T=1.

cheers,
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Postby grok87 » Mon Mar 08, 2010 11:12 pm

Wagnerjb wrote:
As I step back and think about this, the Chevron example makes sense. When your stock price has risen dramatically, you would expect more risk on the downside than the upside. Thus, the "at the money" puts are more valuable than the "at the money" calls. This is exactly what we see with Chevron.


Actually I think it has to do with dividends. Put-Call Parity for at-the-money options on a dividend paying stock says the following:

Stock + Put(X) = Call(X) + X/(1+i-d)^T

X + Put(X) = Call(X) + X/(1+i-d)^T

Put(X) = Call(X) - X* [ 1 - 1/(1+i-d)^T ]

So for 2 year options i=0.88% and Chevron dividend = 3.70%. So in that case i-d is negative and so is 1-1/(1+i-d)^T. In that case the Put is worth more than the call. As you cite the puts (at 75 ) are worth 11.80 vs. the calls at 6.80.

If you look at BRK-B which doesn't pay dividends the at the money puts are worth less than the at the money calls. Since d=0 i-d is positive and so is 1-1/(1+i-d)^T.

cheers,
Last edited by grok87 on Tue Mar 09, 2010 12:05 am, edited 1 time in total.
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Postby Wagnerjb » Mon Mar 08, 2010 11:42 pm

grok87 wrote: In that case the Put is worth more than the call. As you cite the puts (at 75 ) are worth 11.80 vs. the calls at 6.80.

If you look at BRK-B which doesn't pay dividends the at the money puts are worth less than the at the money calls. Since d=0 i-d is positive and so is 1-1/(1+i-d)^T.

cheers,


You may very well be right. But look at a stock that I own - Agilent. It is at $33 today and the Jan. 2012 $35 puts are worth more than the calls. It doesn't pay a dividend, so it appears to break the theory. I also own Amgen, another zero dividend stock. You cannot get at-the-money quotes for Jan. 2012, but the put and call would appear to be at the same price (if you interpolate to the current market price).

So, does the theory say that the at-the-money puts are worth less than the calls if no dividend is paid? If so, what is going on with Agilent pricing?

Thanks.
Andy
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Postby grok87 » Tue Mar 09, 2010 12:15 am

Wagnerjb wrote:
grok87 wrote: In that case the Put is worth more than the call. As you cite the puts (at 75 ) are worth 11.80 vs. the calls at 6.80.

If you look at BRK-B which doesn't pay dividends the at the money puts are worth less than the at the money calls. Since d=0 i-d is positive and so is 1-1/(1+i-d)^T.

cheers,


You may very well be right. But look at a stock that I own - Agilent. It is at $33 today and the Jan. 2012 $35 puts are worth more than the calls. It doesn't pay a dividend, so it appears to break the theory. I also own Amgen, another zero dividend stock. You cannot get at-the-money quotes for Jan. 2012, but the put and call would appear to be at the same price (if you interpolate to the current market price).

So, does the theory say that the at-the-money puts are worth less than the calls if no dividend is paid? If so, what is going on with Agilent pricing?

Thanks.

Hi ANdy,
Re Agilent, are you looking at the Jan 12 options which shows the 35 calls at 3.95 and the 35 puts at 7.20?
http://finance.yahoo.com/q/os?s=A&m=2012-01
If so there are 2 issues:

1) The 7.20 is not reliable. It is the last trade, but that may have been awhile ago. As you have pointed out there is very little liqudiity in some of these options. You need to look at the mid of the bid ask. In this case that is 5.42 for the puts and 3.95 for the calls.

2) THe $2 difference between the stock and the strike does distort things. THe puts are 2 in the money. so you need to take that off the put price to estimate the put at 33. this would reduce it to 3.42. Also the calls are more out of the money than they should be. Don't know how to make this adjustment but the calls at 33 would be worth more than 3.95. So you end up with the calls being worth more than the puts for a non-dividend paying stock as the theory would suggest.

in theory the at the money puts and at the money calls should be equal when i=d. So for a 2 year option where i=0.88% (2 year treasury) if dividend also equals 0.88% then the at the money puts and calls would be equal.

cheers,
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Postby Wagnerjb » Tue Mar 09, 2010 10:30 am

grok87 wrote:2) THe $2 difference between the stock and the strike does distort things. THe puts are 2 in the money. so you need to take that off the put price to estimate the put at 33. this would reduce it to 3.42. Also the calls are more out of the money than they should be. Don't know how to make this adjustment but the calls at 33 would be worth more than 3.95. So you end up with the calls being worth more than the puts for a non-dividend paying stock as the theory would suggest.

in theory the at the money puts and at the money calls should be equal when i=d. So for a 2 year option where i=0.88% (2 year treasury) if dividend also equals 0.88% then the at the money puts and calls would be equal.

cheers,


Thanks Grok. I didn't notice that the last price was so stale.

So....if for a dividend-paying stock the puts are worth more than the calls (assuming a dividend above the risk free rate), then I assume you agree that the cashless collar wouldn't work? I assume the reason your Oracle example worked is because it doesn't pay a dividend, right?

Best wishes.
Andy
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Early exercise & Diversify is overated and defective

Postby Strikeout » Tue Mar 09, 2010 12:31 pm

The only time that efficient hedging ESOs with puts and calls will not far surpass the premature exercise, sale and diversify strategy is if the diversified portfolio far out performs the individual position.

In other words, on average hedging reduces risk and will enhance the options value and can reduce taxes and will preserve the alignment of interests between the employee and the company more than premature exercise sale and diversify.

This can be proven. Just pick a few companies which granted options and I will make a few comparisons and we can track the results weekly.

This is essentially because early exercise forfeits the remaining "time premium" and requires an early tax most of which is withheld. These disadvantages will only rarely be overcome by favorable movements of the diversified portfolio relative to the stock movement.

The restrains against hedging are overstated and the relative advantages are understated by those who have little or no experience with hedging.

I know of none ever prosecuted or who lost his job for hedging. Most companies do not restrain hedging, although some do.

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Postby Wagnerjb » Tue Mar 23, 2010 10:15 pm

Wagnerjb wrote:My comments about taxes were aimed at situations where tax rates would be different between years. Say your option has a 10 year life and you are near the end of year 9. You got a great big bonus this year and are in an unusually high tax bracket, maybe paying AMT as well. This guy would wait a few months to exercise. Another guy might not have any unusual income issues, but he sees that Congress is raising tax rates for next year. He might exercise today.

A third guy might exercise some of his shares....just enough to stay in the lower tax bracket. This would be identical to the tactic used by many when they convert an IRA to a Roth.

That is the kind of decision that you simply cannot put into a formula.

Best wishes.


We now have a real-life situation where tax rates should be factored into the exercise decision. Say you have 10-year options that expire in February 2013 (I actually have these). Let's say you have salary of $225,000 and dividends & interest of $25,000. Your options are worth $75,000.

You could exercise early and save on taxes. In 2013 you will be paying 36% instead of 33% as your marginal income tax rate is higher (due to the expiring tax cuts in 2011). In 2013 you will pay an additional 3.8% on the $25,000 of dividends and interest - due to the exercise. In addition, the exercise (assuming NQ options) will drive your earnings over $250,000, subjecting you to an additional 2.35% tax on $50,000 of the option income.

Should you exercise in 2010 to avoid the 3% in higher income tax? I would think not since you are giving up 3 years of potential gains. Should you exercise on December 2012 instead of February 2013? HECK YES! Here you get a combined rate maybe 3% lower but you aren't really giving up any time value at all.

Best wishes.
Andy
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Re: Got Employee Stock Options? Grok's rule for when to exer

Postby grok87 » Thu Jul 12, 2012 10:53 am

Here is a new post of mine regarding employee stock options. Same basic approach...

viewtopic.php?f=10&t=99385
cheers,
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Re: Got Employee Stock Options? Grok's rule for when to exer

Postby hansp » Mon Mar 25, 2013 2:19 am

grok (or anyone else),

How would a dividend affect your "rule of thumb" formula? Obviously it would reduce the time value of the option (and I see the reference to that in this thread), but how would you account for that in your percentage calculation?

I've got some options I'm trying to figure out how to handle, and my employer's stock has an ~ 4% dividend yield currently.

This thread and others by you and WagnerJB among others have been very helpful in getting my head wrapped around some basics and strategies to consider.

Putting in my numbers into your rule of thumb (w/o dividend) gives values that make sense to me, however I'm trying to figure out how much I should adjust them to take the dividend into account.

Thanks.

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Re: Got Employee Stock Options? Grok's rule for when to exer

Postby grok87 » Mon Mar 25, 2013 9:20 pm

hansp wrote:grok (or anyone else),

How would a dividend affect your "rule of thumb" formula? Obviously it would reduce the time value of the option (and I see the reference to that in this thread), but how would you account for that in your percentage calculation?

I've got some options I'm trying to figure out how to handle, and my employer's stock has an ~ 4% dividend yield currently.

This thread and others by you and WagnerJB among others have been very helpful in getting my head wrapped around some basics and strategies to consider.

Putting in my numbers into your rule of thumb (w/o dividend) gives values that make sense to me, however I'm trying to figure out how much I should adjust them to take the dividend into account.

Thanks.

Hans

Hans,
I agree that factoring in the dividend would reduce the time value of the option and thus make you lean more towards exercising them sooner rather than later. I have been thinking about how to factor that into the formula but don't have anything yet.

Another way to estimate the split between the time value and the intrinsic value of the option is to look at publicly traded options that have similar volatility and dividends. Morningstar has this sort of info.
http://quote.morningstar.com/Option/Opt ... ticker=PFE
cheers,
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Re: Got Employee Stock Options? Grok's rule for when to exer

Postby hansp » Tue Mar 26, 2013 3:07 am

A potential dividend correction:

(Disclaimer, I'm mathematically inclined, but know nothing about options pricing and models outside of what I've read recently on various websites)

I found the Noreen-Wolfson option model, which corrects Black-Scholes for dividends and dilution. The correction for dividend yield is to divided the current price by e^(d*T), where

d is the dividend yield (decimal)
T is time remaining


If I approximate e^(d*T) as 1+dT, and then divide the time component of grok's rule of thumb, I get:

p = i*T / [(1+dT)*(S/X-1)]

Note, d is a fractional number, i.e. 0.04 for 4% yield

In my case, w/ a dividend yield of ~3.4%, this had the net effect of scaling p down by ~10-20% from the non-dividend value, which feels about right. (reduction gets larger as time increases)

I like this as it collapses to the original equation as d goes to 0 and reduces p as the dividend gets larger.

Comments or suggestions? Is the correction too large or small?
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Re: Got Employee Stock Options? Grok's rule for when to exer

Postby grok87 » Wed Mar 27, 2013 7:12 pm

hansp wrote:A potential dividend correction:

(Disclaimer, I'm mathematically inclined, but know nothing about options pricing and models outside of what I've read recently on various websites)

I found the Noreen-Wolfson option model, which corrects Black-Scholes for dividends and dilution. The correction for dividend yield is to divided the current price by e^(d*T), where

d is the dividend yield (decimal)
T is time remaining


If I approximate e^(d*T) as 1+dT, and then divide the time component of grok's rule of thumb, I get:

p = i*T / [(1+dT)*(S/X-1)]

Note, d is a fractional number, i.e. 0.04 for 4% yield

In my case, w/ a dividend yield of ~3.4%, this had the net effect of scaling p down by ~10-20% from the non-dividend value, which feels about right. (reduction gets larger as time increases)

I like this as it collapses to the original equation as d goes to 0 and reduces p as the dividend gets larger.

Comments or suggestions? Is the correction too large or small?

hmm.. sounds reasonable but i'm not sure. still thinking about it. I think the real way to do this is to start with the black scholes formula (corrected for dividends) and do a series expansion...
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