When should you reduce the Risk of Holding Employee Stock Options

When is the risk greatest when holding in-the-money vested Employee Stock Options?

Isn't it logical to want to reduce risk when the risk is greatest rather than a time when the risk is less?

It goes without saying that the risk of loss on a position in employee stock options is greater when the chance of losing all of or a large part of the options value is much greater than when that stock is trading at a different price?

So it seems to me to that the first step in deciding when to reduce the risk of holding employee stock options is to determine when the risk is greater.

Below are links to presentation which illustrates when the risk of holding in-the-money employee stock options is greater than another position.

http://www.slideshare.net/fullscreen/OLAslideshare/risk-calculation-of-eso-positions-sheet1-4/1

https://docs.google.com/spreadsheet/ccc?key=0AtBngJz5Vy2WdG02cUIxNDdVb1JONm1rbVA1dzA3Snc#gid=0

It is easy to prove that the risk of holding ESOs when a stock is 50% above the strike price is greater than when the stock is 100% or 125% above the strike price.

It is also just as easy to prove that the chance of a stock going from $75 to $50 is similar to the chance of the stock going from $75 to to $110 after a substantial amount of time and with a 35 to 40 volatility.

The exact difference in risks depends on the volatility, the time to expiration and the interest rate, but the risk will always be greater when the stock is trading at $75 with a $50 exercise price than when the same stock is $110 with a $50 exercise price.

Since the risk of substantial loss is greater when the stock is 50% above the exercise price than when the stock is 110% above the exercise price, and since the probability is about the same for the stock going back to $50 from $75 as it is of going to $110, is there anyone other than Craig McCann and Kaye Thomas who would claim as they did in their paper "Optimal Exercise of Employee Stock Options and Securities Arbitrations" that you should wait until the stock goes to 110% above the exercise price and then exercise, sell and "diversify". 

The next step is to determine how much risk you should reduce. That amount depends on how risk averse you are or should be.

The next step is to determine what is the most efficient way to reduce risk. The only efficient way to reduce risk is to sell exchange traded calls and to a lesser degree buy puts. Often sales of vertical call spreads or purchases of vertical put spreads can be the best strategy considering everything. The strategy of making early exercises and selling stock and "diversifying" should be avoided except in rare circumstances.

John Olagues

0lagues@gmail.com

http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html