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The purposes of this paper are to define share leverage, a previously unrecognized factor in the decision of whether to exercise employee stock options ESOs early, and to delineate how wealth maximizing early exercise decisions regarding ESOs are dependent upon share employee stock options hedging. This investigation is important, because understanding share leverage is essential to holders of employee stock options employee stock options hedging wish to maximize personal wealth and to financial advisors who employee stock options hedging clients in such matters.

ESOs are a type of American call option. While they have similarities to plain vanilla listed call options, ESOs have other attributes that make their valuation more complex. Also, similar to warrants, the typical time-to-maturity of five to ten years from the date of grant is very long when compared to the standard listed option. However, for the purposes of this paper, the key valuation-related feature of ESOs is their lack of marketability.

ESOs cannot be employee stock options hedging by their holder, and they cannot be transferred other than by will. In addition, ESOs may only be exercised by the holder, so they are worthless to other parties. Huddart shows that nonmarketability creates conditions where early exercise of ESOs will be optimal for a sufficiently risk averse holder.

The nonmarketability of ESOs coupled with legal restrictions on hedging an ESO via employee stock options hedging short sale employee stock options hedging the underlying stock, result in early employee stock options hedging sometimes being the rational choice, even for ESOs on non-dividend paying stocks.

This result is in conflict with traditional option theory. Merton demonstrates theoretically that American call options, like European call options, on non-dividend paying stocks should never be exercised prior to maturity. The rational holder of a call would never willingly destroy value he or she could garner. If the holder of a vested ESO believes the underlying stock is about to decline in value, the holder cannot sell the option, but must instead exercise it and sell the underlying stock.

While existing ESO literature has shown that the combination of marketability and short sale restrictions is sufficient to make early exercise a viable strategy, the literature has not properly noted the impact of another factor on the early exercise decision.

A given dollar investment can purchase call options on more shares than it can shares of the underlying stock itself. If the stock advances sharply in price, the call holder earns a higher return than the stockholder. While this leverage feature of options has employee stock options hedging noted in existing options literature, employee stock options hedging importance in the early exercise decision of ESO holders has not been.

Later I define a complex measure of share leverage. As will be shown, share leverage plays an important role in the early exercise decision, although it greatest importance is to ESO holders who employee stock options hedging deciding whether to exercise early, immediately sell the stock, and then repurchase at a later date.

When share leverage is lost, the holder loses some capacity to benefit from share price increases subsequent to the anticipated repurchase date. This paper is divided into several sections. The first section discusses some additional characteristics of employee stock options.

The second section contains the main results of the paper. Finally, the paper concludes with a brief summary. The concern here is only with the individual holder, and any firm-related tax effects are ignored.

Nonqualified options, when exercised, are taxed as ordinary income to the holder on the difference between the exercise price and market price. Incentive stock options are usually taxed only when the stock is sold, with the difference between the exercise price and the sales price being taxed as a capital gain.

The two classes thus differ in the relevant tax rate T and the timing of the tax payment. Unless the holder is leaving the firm, there is little reason to exercise an ESO early without simultaneously selling the stock, so with regard to binary-options-clubcom best binary options to trade early exercise decision we can generally treat the two types as alike.

To employ the model developed below, one need only insert the appropriate tax rate to account for the difference in tax treatments. See Mozes for a more complete discussion of taxes and the costs of ESOs to the firm. See Huddart for a discussion of how a proposed tax rate increase increases the frequency of early exercise for employees likely to be affected by the increase.

Notation and the Model First consider the simple case of a risk neutral ESO holder who does not intend to repurchase the underlying stock at a later date. Notation and basic assumptions: The early exercise decision for a risk neutral holder who does not intend to repurchase the stock at a later date depends on basic time value of money relationships.

Generally, the risk neutral holder should exercise whenever. Unless the holder expects a change in tax rate, taxes are not important to the exercise decision, because both sides of 1 and 2 are multiplied by a common factor, 1-T. Equation 2 should only be applied when the holder does not employee stock options hedging to reinvest the proceeds from early exercise at a later date in the same stock.

If the holder either intends to reinvest or might consider reinvesting in the same stock at a later date, he should weigh any share leverage changes. Share leverage must be considered, because the employee stock options hedging of an ESO who exercises early employee stock options hedging an immediate loss in share leverage.

This is a loss in share leverage. Paying taxes on the stock sale would further magnify this loss and can be considered another, though separable, component of the loss in share leverage.

Note that no one would ordinarily exercise an ESO, sell the stock and then immediately repurchase the stock. Share leverage is most important in cases where the holder intends to repurchase the stock at a later date or would consider doing so. Such an intention might be fostered by an expected near term decline in the value of the underlying stock and expected subsequent increase.

Suppose an ESO holder forms a price forecast for q periods in the future. When share leverage is lost, the holder's ability to benefit from price employee stock options hedging after the anticipated repurchase date is diminished. Suppose the holder of an ESO is trying to reach a decision about early exercise. To decide between early exercise and holding the option to maturity, the risk-neutral trader need only employee stock options hedging determine in which instance her wealth will be greater at expiration.

It can be equal to, greater than or less that one. Perceived gains in share leverage make the early exercise decision easy — the trader should exercise her ESOs early and repurchase the stock at a later date.

All else equal, the wealth maximizing choice will depend on the expected price path of the underlying stock. To keep the notation tractable, we assume that the trader forecasts stock prices for q dates into the future and for the expiration date. Obviously the model below could be applied to terminal dates employee stock options hedging to the expiration date. The RHS represents the expected per share wealth from waiting until expiration to exercise. Equation 4 provides an upper bound on the expected stock price at expiration, P 0above employee stock options hedging the trader should not exercise early.

A general solution on the upper bound on P 0 above which early exercise will be sub optimal can be obtained by rearranging equation 3 as:.

To review how share leverage as defined here affects the early exercise decision: Employee stock options hedging inability of the holder to sell the ESO prevents the option from possessing realizable time value in excess of the stock price minus the exercise price.

While the value of a typical American call option prior to expiration is greater than P - X, the nonmarketability of an ESO effectively eliminates this value difference.

As a result, circumstances arise in which early exercise is optimal for a rational holder. Recall we had assumed risk-neutrality. This was done to simplify later notation and analysis. To incorporate risk aversion into employee stock options hedging analysis, the following version of 2 would be more appropriate: They find that value is decreasing in risk aversion and stock holdings and increasing in non-firm related wealth.

Their model does not address early exercise or share leverage. HeathHuddart and Lang find that, consistent with psychological models of belief, employees exercise ESOs early in response to stock price trends.

They employee stock options hedging that exercise is positively related to recent returns. The model in this paper would enable employees to make a more informed decision. I have assumed for simplicity that r is a risk free rate, but r can be any reasonable rate the trader chooses to use.

The higher the r at which the proceeds of early exercise can be reinvested, the more likely is early exercise. Accounting, Valuation and Management Issues. Financial theory clearly demonstrates that marketable options on non-dividend paying stocks should never be exercised early.

However, empirical evidence shows that early exercise of employee stock options ESOs is a pervasive phenomenon. Finance theory and actual practice are at odds because ESOs cannot be sold or transferred by their holders -- a violation of the liquidity assumption in option pricing models. Holders of ESOs who wish to maximize personal wealth and financial advisors who employee stock options hedging clients in such matters need to understand the circumstances in which early exercise early is beneficial.

End N otes 1. Sources Coopers and Lybrand.

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30 comments Company stock option basics

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Well, there is a way to make money on these employee stock option grants regardless of what happens to the company share price. Some companies allow up to 10 years until a grant must be exercised. These options vest immediately and are good for 5 years.

In order to do this, you can sell call options against your underlying option grant on a 1: If you wanted to be able to capture some of the upside, but ensure some immediate income as well, you could do the following:. First, you need an online broker. Open an account at TradeKing. Generally, upon signing up for an account, you would need to sign a form stating that you understand the risks of options trading and selling short.

You would also need to have some collateral in your account. So, if you were granted options on Jan 1, , the earliest call options you should sell would be Jan strike. This is an exercise in Tradeoffs. Insider trading is one thing. That would entail making trades on either company stock or options while in material possession of knowledge not available to the public. Please elaborate on the actual rationale for concern.

Perhaps this would make for a good follow-up article. Now most companies will have a covenant that you need to sign in order to get your grants. It will specify what the rules are. Companies look bad when their employees are trading against them. How would it look if your directors shorted the company stock outside the blackout period?

And the option grants are to align the interests of the employees, managers, etc… along with the managers so that they are long with the company. Hedging takes that away. For these reasons, the covenants rule out derivatives trading.

This is not an SEC ruling but a contractual and policy issue between the employee and the company. However, is it any different than when you get a restricted stock grant and sell it right away? I view it as a diversification strategy — you already have your salary, your bonus and your livelihood tied to the company — why double dip by having excess options, owning company stock, etc. Darwin, I loved this post. It is a great idea and makes complete sense. In reference to the discussion above, at my company there is no restriction against this type of thing.

Once the options are vested, they are yours to do with as you with. Recently, Joe at ioptions contacted me to highlight a recent SEC ruling that allows who own stock options to generate income from their unexercised holdings. Interestingly, while this article speaks to the margin issue, in effect, it endorses the legality of the concept above then, right?

I mean, the SEC has now gone even a step further in dealing with a margin issue and skipped right over whether employees should have even been doing it in the first place. This will create an interesting situation for companies that do have a policy prohibiting it as mentioned by some previous commentors. I have some employee stock options of the company I work, so this article s of great interest to me. However, when I called ETrade and TradeKing, the trade representatives of both of the companies told me that cannot be done, i.

Thank you for your quick reply. What you said makes sense. The only issue I can see is that there is no way to link the filling of the naked call with the exercise of the employee stock option, since the blockage, say Ameritrade, handles the naked call will not be able to sell the employee stock option which is held at another blockage, say Etrade.

Of course, it is only slight increase in risk factor but nevertheless not perfect. Moreover, I am work full time so may not be able to do these trades in real time. I need to find out how to increase my trading level first.

Thanks for your help anyway. I have one trading account, and then my employee options are held in some other account that the company established, Citi or SmithBarney or something. Anyway, if you want to avoid any volatility that may occur in a single day which will likely be small if your horizon was say 1 year out — i. If your company only exercises options based on the price at close of trading, you could close the options transaction right at 3: So, a few options out there to mitigate the timing risk.

I opened a TradeKing account based on your suggesting. Even it is only a few days, I feel their customer service is really great and everything are handled perfectly, as far as I can tell. BTW I am usually a picky person. Someone suggested that i can do a spread by write a call equivalent to the naked call I want to do and then buy a call at higher price to cover it.

If the second call is much higher, it will not cost much. Spreads requires lower option trading level then naked calls because they involve less risk. Do you think this will work? Thanks again for your good suggestions that led me to start this effort. Covered call is not viewed as short sell but uncovered call is. On the company issue, yes, varies company by company — mine was silent on the topic, so I figure no policy against.

If in doubt, check it out! It operates with the same logic as a 10b plan. You can use these HTML tags and attributes: Notify me of followup comments via e-mail. Notify me of follow-up comments via e-mail. A Lesson in Volatility prior to Earnings Releases: Almost all option grant contracts forbid employees from trading options. Frank [ Reply ]. Sincerely Frank [ Reply ]. Click to cancel reply. The opinions are those of the author only. It is recommended that you conduct independent research and consult a certified financial adviser before making any investment or financial decisions based on content from this blog.

No responsibility will be accepted for adverse events that may result as a consequence of acting on the information presented herein.