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  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: Basic Hedging Strategies
  8. Employee Stock Options: Conclusion

The biggest and most obvious difference between Employee Stock Options (ESOs) and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options. We compare ESOs to exchange-traded options below.

The value of your ESO is not easy to ascertain

Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time. LEAPs (Long-Term Equity Anticipation Securities) are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration. Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required – on the options grant date – to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. (Related: Get The Most Out Of Employee Stock Options - Video)

Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices. If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. It may be a good idea to get several estimates from other models to compare them with your compnay’s valuation of your ESOs.

Specifications are not standardized

Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm. If you trade a call option contract, for instance, you have the right to buy 199 shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell 100 shares of the underlying stock until expiration. While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement.

No automatic exercise

For all listed options in the U.S., the last day of trading is the third Friday of the calendar month of the option contract. If the third Friday happens top fall on an exchange holiday, the expiration date moves up by a day to that Thursday. At the close of trading on the third Friday, the options associated with that month’s contract stop trading and are automatically exercised if they are more than $0.01 (1 cent) or more in the money. Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own 100 shares through the automatic exercise feature. Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short 100 shares through the automatic exercise feature. Note that despite the term “automatic exercise,” you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration. With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options.

Strike Prices

Listed options have standardized strike prices, trading in increments such as $1, $2.50, $5 or $10, depending on the price of the underlying security (higher priced stocks have wider increments). With ESOs, since the strike price is typically the stock’s closing price on a particular day, there are no standardized strike prices. In the mid-2000s, an options backdating scandal in the U.S. resulted in the resignations of many executives at top firms (see Backdating: Insight into a Scandal). This practice involved granting an option at a previous date than the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder. Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days.

Vesting and acquired stock restrictions

Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer. As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions. However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread (as discussed earlier) and now hold a stock that you cannot sell (or that is declining). 

Counterparty Risk

As scores of employees discovered in the aftermath of the 1990s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs. With listed options in the U.S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. Thus, there is zero risk that the counterparty to your options trade will be unable to fulfill the obligations imposed by the options contract. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock.

Concentration Risk

You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock. In addition to your ESOs, if you also have a significant amount of company stock in your ESOP, you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA (see Putting too much stock in your company – A 401(k) problem).

Employee Stock Options: Valuation and Pricing Issues
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