With potential tax increases ahead, your employees have more questions and concerns about year-end planning

Bill:

You are correct that the ESOs, immediately after vesting, do still have substantial amounts of "time value" remaining unless the stock is trading far above the exercise price and/or has a low volatility. It would be premature to make an exercise at that point in most cases.

 The question then becomes when is it appropriate to exercise your options.

If you believe that Blankfein, Cohn, Dimon, Chambers, Ellison and Jobs and many other top executives got the best advice, then the time to exercise is right prior to expiration. 

But for the regular manager who has a substantial amount of vested ESOs that are substantially in-the-money, he may be interested in risk reduction. He has only two choices, a) early exercise, sell and diversify or b) do as 135 executive of Goldman Sachs did. They sold calls versus vested ESOs. My contention is that in the great majority of the cases, selling calls is the only efficient strategy if risk reduction is desired. That is why I offer to the have the other wagere pick the stock and the circumstances. If, in the case where there is little or no "time value" remaining, the advantage of selling calls is not that great, although there is still some advantage even then.

The advantage of selling calls is substantial when there is a decent amount of "time value" remaining. In cases when the value of the remaining "time value" correctly calculated is 10-15% of the "intrinsic value", exercising is too early and calls should be sold. I am willing to wager that it is.

No one has ever and no one will ever demonstrate that the strategy of making early exercises when there is "time value" of 10 - 15% of the "intrinsic value is efficient. If it was then Blankfein, Cohn, Dimon, Chambers, Ellison, Jobs would have done it.

John Olagues

John,

CEOs such as the ones you cite are precluded from using hedging strategies so if they don't understand the Insight Ratio process for monitoring their options then the only alternative is to wait until right before expiration. 

I realize that using hedging strategies as a means of reducing the risk of holding employee stock options can be very effective.  There are just a number of barriers to implementing these strategies:

• Officers and insiders can not use them


• They can only be applied to publically traded companies that have market traded options


• Implementation is highly complex and usually requires the assistance of an option expert such as yourself


• Most advisors and stock plan professionals don't understand market traded options or ESO hedging strategies and therefore can't/won't recommend them


• The individual needs to have option trading approval and a margin account

Since there are very few individuals using ESO hedging strategies, the barriers seem to outweigh the benefits.

Bill:

It may be the case that everyone of the CEOs that I mentioned were prohibited from hedging by the Options or SARs contracts between themselves and the company. However, there are no SEC rules that prohibit selling at-the-money  calls or out-of-the-money calls while holding vested substantially in the money ESOs or SARs.

My point in mentioning those CEOs was to illustrate that they waited to the end to exercise their ESOs and SARs and did not exercise substantially prior to expiration even though the "time value" was zero or very small. After they exercised they immediately sold the stock. The idea that exercising substantially prior to expiration, selling and diversifying the net after tax proceeds has some merit must have not been appealing to them.

It is true that to sell exchange traded calls, there must be a liquid market in the calls.

Any stock broker can execute the trades and I am sure that there are Wealth Managers who can and do it also. I agree that most advisors will not try the risk reducing strategies that I suggest. Why they do not, I am not sure of.

Yes the grantee would need a margin account and options trading approval. The approval is not that hard to get, especially if the client is advised by someone who is experience with risk reduction use of calls and puts.

Thanks for the replies.

john