1. For ESO Holders and their Advisers... June 10, 2010, 2010On Oct 5, 2009. I sent the email newsletter below: ================================= ================ 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.------------------------------------------------------------ 3. ----- Assume various prices of Apple stock when the calls and puts expire.Apple StockValues *P and L P and L ESO ValuesValue of ESOs + Price on of ETFon callson Puts3 yrs. expected call and put profit. Jan 2012time to expiration Expiration130 $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. ------------------------------------------------------------ ------------------------------------------------------------ ------------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. ================================= ================================= ============= 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 +$44,400Totals from the hedging strategy is the following:Calls sold = -$16,000 Puts bought = - $2,940 Gain on ESOs +$ 44,400Net total gain = + $25,460 gain from the hedging strategy =================================The Standards and poor index is up from 1054 to 1091 or up 3.5 percent. The $171,000 would therefore beequal to $171,000 x 1.035 = $176,985.Net total Gain = + $5,985 gain from the diversified portfolio------------------------------------------------------------ - 6. Of course the 800 shares have made a profit of $12,472 for each position =================================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".------------------------------------------------------------ - January 28, 2010 updateNow 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 http://www.wiley.com/WileyCDA/WileyTitle/productCd -0470471921,descCd-description.html