1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Premature Exercise Risks
  8. Employee Stock Options: Conclusion

By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.com

While premature exercise is a dependable solution to lock in intrinsic value, it can prove costly. Aside from the hold-to-the-bitter-end approach, few alternatives are offered by traditional financial advisors and wealth managers. Yet, it is becoming more prevalent to find some financial advisors (who have expertise in options) using listed options to both hedge downside intrinsic risk and capture and retain time value, plus better manage tax liabilities. It is even possible to cash out some equity through call selling along the way. Overall, it can be demonstrated that hedging approaches using listed options can maximize potential gains and minimize tax liabilities, even with worst-case tax rules applied.

The tax picture gets more complex when hedging approaches are applied, but if you become familiar with certain rules, such the IRS straddle rule (and an "identified straddle"), wash rule, constructive sale and a few others (be sure to consult a tax accountant on any matters regarding your ESOs), using simple put buying and call selling approaches correctly offers the possibility to construct alternative scenarios and get superior outcomes, and with less risk.

As we've seen, early exercise may not always be necessary to manage gains in an ESO portfolio. For example, when you buy listed puts on the same underlying stock in your ESO, you can put a floor on downside losses should you have intrinsic value in your ESOs. The cost of purchasing those puts can be offset by selling out of the money calls, known as a costless collar While just one example, it will remove some downside risk, simultaneously keeping some upside potential whenever putting on hedges of this type. Overall, hedging with puts and calls has special benefits in the tax liability area. (To learn more about collars, see Putting Collars To Work.)

Changes have occurred in the regulatory environment to make hedging of ESOs a much more attractive option for the retail trader, namely, much lower margin requirements for call selling. And the retail brokerage industry has gotten much better at making account setups, trading platforms, educational webinars and analytical tools available to new options traders, which makes the learning curve much shorter for trading listed options.

Most listed options are traded online with the click of a mouse, and you can set up your trades online and get prices on them with streaming real-time quotes, now provided by the brokers, for no cost except maybe an exchange fee. Years ago, you would have had to fork over quite a bit of money for real-time streaming options and stock price quotes boards, and with all the charting abilities. Not anymore. We live in a new world today, where service is the driving force of competition.

Whatever choices you make regarding your ESOs, be sure to consult an expert in taxes and in options trading. Most of the hedging concepts are relatively simple but application may not always be as easy as it may seem. And most importantly, get informed and ask the tough questions when you sit down with your financial planner or wealth manager. And be sure to ask them to explore non-traditional alternatives.

For more on employee stock options, read our related articles Get The Most Out Of Employee Stock Options and Mapping Out The Stock Options Landscape.

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