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

We discuss some basic Employee Stock Option (ESO) hedging techniques in this section, with the caveat that this is not intended to be specialized investment advice. We strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager.

We use options on Facebook (FB) to demonstrate hedging concepts. Facebook closed at $175.13 on November 29, 2017, at which time the longest-dated options available on the stock were the January 2020 calls and puts. (Related: Hedging Basics: What Is A Hedge?)

Let’s assume you are granted ESOs to buy 500 shares of FB on November 29, 2017, which vest in 1/3 increments over the next three years, and have 10 years to expiration.

For reference, the January 2020 $175 calls on FB are priced at $32.81 (ignoring bid-ask spreads for simplicity), while the January 2020 $175 puts are at $24.05. (Related: Hedging With Options)

Here are three basic hedging strategies, based on your assessment of the stock’s outlook. To keep things simple, we assume that you wish to hedge the potential 500-share long position to just past three years, i.e. January 2020.  

  1. Write calls: The assumption here is that you are neutral to moderately bullish on FB, in which case one possibility to get time value decay working in your favor is by writing calls. While writing naked or uncovered calls is very risky business and not one we recommend, in your case, your short call position would be covered by the 500 shares you can acquire through exercise of the ESOs. You therefore write 5 contracts (each contract covers 100 shares) with a strike price of $250, which would fetch you $10.55 in premium (per share), for a total of $5,275 (excluding costs such as commission, margin interest etc). If the stock goes sideways or trades lower over the next three years, you pocket the premium, and repeat the strategy after three years. If the stock rockets higher and your FB shares are “called” away, you would still receive $250 per FB share, which along with the $10.55 premium, equates to a return of almost 50%. (Note that your shares are unlikely to be called away well before the three-year expiration because the option buyer would not wish to lose time value through early exercise). Another alternative is to write one call contract one year out, another contract two years out, and three contracts three years out.
  2. Buy puts: Let’s say that although you are a loyal FB employee, you are a tad bearish on its prospects. This strategy of buying puts will only provide you downside protection, but will not resolve the time decay issue. You think the stock could trade below $150 over the next three years, and therefore buy the January 2020 $150 puts that are available at $14.20. Your outlay in this case would be $7,100 for five contracts. You would break even if FB trades at $135.80 and would make money if the stock trades below that level. If the stock does not decline below $150 by January 2020, you would lose the full $7,100, and if the stock trades between $135.80 and $150 by January 2020, you would recoup part of the premium paid. This strategy would not require you to exercise your ESOs and can be pursued as a stand-alone strategy as well.
  3. Costless collar: This strategy enables you to construct a collar that establishes a trading band for your FB holdings, at no or minimal upfront cost. It consists of a covered call, with part or all of the premium received used to buy a put. In this case, writing the January 2020 $215 calls will fetch $19.90 in premium, which can be used to buy the January 2020 $165 puts at $19.52. In this strategy, your stock runs the risk of being called away if it trades above $215, but your downside risk is capped at $165. 

Of these strategies, writing calls is the only one where you can offset the erosion of time value in your ESOs by getting time decay working in your favor. Buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk, while the costless collar has minimal cost but does not resolve the issue of ESO time decay.

Employee Stock Options: Conclusion
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