.

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 OptionsExtend the Purpose of the Options Grant? Whenever I speak with a person who has some experience withemployee stock options, I generally get the comment thathedging by selling calls defeats the object of the options grant.The person claims that the purpose of granting ESOs isto align the interests of the company with the interests of the executives.

.

The claim is that hedging the ESOs essentially reduces the equity position of theexecutive 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.

.

Let's look at the idea closely:

We will do so by way of an example:

Many executives these days own stock along with theiremployee stock options. Let us assume that an executive owns4000 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 stocktrading at $75 (a high risk position).In traders lingo, the two combined positions may have a deltaof long 12,700 shares (i.e. +4000 from the stock and +8700from the options). So here the executive could be perceivedas owning the stock equivalent of 12,700 shares.

.

If he/she were to a) sell the 4000 shares (which is not discouragedby the company) he/she would reduce the deltas by 4000 sharesand thereby reduce the alignment by 4000 shares. If he/she were to b) prematurely exercise ESOs to purchase 4000shares and sell the stock received, the deltas would be reduced byperhaps 3480. This of course is not discouraged by the companyafter vesting even though it will have reduced the executivesalignment with the company by 3480 stock equivalents.If he/she were to c) sell the 4000 ESOs on some new transferableoptions plan, his delta would be reduced by 3480, thereby reducing the alignment accordingly.

.

This type of transferable option was introduced by Google at the encouragement of Morgan Stanley.

If he/she were to d) sell (write) listed LEAP calls on 4000 shares ofstock with an exercise price of $80 against the 4000 shares, this would reduce the deltas by perhaps 2400. The alignment would be lessened by the 2400 deltas.

.

So why would the company discourage or prohibit d) and not discouragea), b) or c), because a), b), and c) all reduce the alignment more that d).Some companies actually try to use their Insider Trading Policyto prohibit the sale of calls, when there is no prohibition in the Stock Plancontract document or the Grant Agreement contract. Their doing so makesearly exercises of ESOs the only way to reduce the risk of holding substantiallyin-the-money ESOs. The consequence of early exercises and sale is to create the early cash flows to the company 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 theeyes of the informed executive/grantees. This reduction of valuerequires a larger grant to those executives to create the sameincentive. If the call selling was not discouraged, the executiveswould perceive the ESOs to have more value, thereby requiring lesstotal options granted.

.

If companies were to encourage a gradual selling of exchange traded calls against the ESOs from the date of vesting to expirationday, this would create more value in the eyes of the executives and require fewer grants and less expenses against earnings. This wouldalso provide executives with an efficient way to exit his/her options positions, reduce risks and delay taxes.

John Olagues504-875-4825

http://www.amazon.com/Getting-Started-Employee-Stock-Options/dp/0470471921