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To Employee Stock Optionees and their Advisers
Margin Requirements for hedging ESOs:
Some
detractors of hedging ESOs claim that, given the present margin
requirements, cash deposits for selling naked calls make hedging
impractical or prohibitive. The purpose of this newsletter is to set
the record straight.
The minimum margin requirements for selling calls are:
1.
If the calls are 10% or more out-of-the-money (i.e. if the exercise
price is more than 10% above the market price of the stock), the
initial margin requirement to sell a "naked" call is 10% of the value
of the stock.
2. If the calls are at-the-money, the initial requirement is 20%.
For Example:
If you have no stock or other securities and you wish to sell one "naked" January 2011, 470 LEAP call on Google stock which is trading at 425,
the initial margin requirement is $4,250. The expected market value of
the option is $5,900. If the stock advances you will have to deposit
more cash or marginable securities. If the stock declines you can
withdraw part of the $5,900 cash proceeds from the sale.
If you wish to sell the January 2011, 425 LEAP call on Google, the initial margin requirement is $8,500. The sales proceeds would be about $7,700
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Let us examine the amounts of stock and options that you, as a typical employee/manager might have.
a) Long 100 shares of stock fully paid for
b) Long 300 ESOs exercisable at 250 (vested or not)
Suppose
you sell (write) 3 LEAP calls with a strike price of 470 expiring in
January 2011 for a total of $5,900 each, resulting in a covered write
against the stock and 2 ESOs considered "naked" for margin purposes.
Each call had a .50 delta.
Do you, the emplyee/manager, have to deposit margin to initiate the short call position? Answer is No.
If
you own the stock and it's fully paid for, you merely deliver it to
your margin account. Its value is $42,500. After the sale of the
covered call, the proceeds of $5,900 go into your account and earn
interest. You would have excess margin of $27,100. The margin
requirement on the sale of the two other calls with the 470 strike
price is $8,500, giving you, the hedger, $18,650 of excess margin as
protection against future moves upward. You would receive interest on
the proceeds of $17,700 (i.e. 3 x $5900).
Analysis of the deltas (equivalent stock position) :
Prior
to the sale of the three calls, your delta position was +100 for the
shares plus 3 x 85 for the 3 ESOs. Your total summed delta was +355.
After
the sale of the calls, your summed deltas would be +205 (i.e. +355 - (3
x 50) ). So your summed deltas are reduced by about 42% with the sale
of the three calls.
If there is an extreme move upward, your
partially hedged position would make a large gain considering all
positions, including the ESOs. If the extreme up-move would cause a
margin call using up all of the excess margin, you could merely
exercise one of your vested ESOs to eliminate the margin calls. You
merely deposit the stock received or sell the stock and deposit the net
after tax cash amount into your margin account.
If there is an
extreme up move and you wished not to exercise an ESO, you could merely
sell the 100 shares of stock that you own already and buy back one of
the short calls. That would eliminate the margin requirement.
Some
have expressed the view that present cash margin requirements make
selling "naked" calls to hedge ESOs prohibitive or impractical. That
view is misguided and deliberately deceptive.
Conclusion
Of
course if you have no stock long and no cash avaiable in a bank
account and no cash in an IRA, the margin requirement would make
hedging ESOs unavailable. But then you probably have just an incidental
amount of ESOs making it such that the effort of opening a brokerage
account and performing hedging tranactions is not worth the time.
If
the hedger is an officer or director he must be aware of the
Securities Act of 1934 and SEC Rules promulgated thereunder,
especially Section 16b and Rule 16c-4.
All ESO holders must be
aware of the impact of IRS Statutes and Rules upon hedging strategies
especially IRS sections 1091,1092,1259,1221 and IRS Publications
550(2008) and 525 (2008).
John Olagues
P.S. I know of
very few advisers who sufficiently understand the application of IRS
and SEC Statutes and Rules in order to efficiently apply hedging
strategies for employee stock options. Out of those few, the group who
also has experience managing substantial options positions is even
smaller.
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