GETTIN

G S

TAR

TED INEMPLOYEE STOCK OPTIONS

Investing

$19.95 USA / $23.95 CAN

G E T T ING S TA R T ED IN

EMPLOYEESTOCK OPTIONS

JOHN OLAGUES & JOHN SUMMA, PHD

OLA

GU

ES • S

UM

MA

Cover Design: Wendy MountCover Illustration: (chart) © Istockphoto; (people) © Illustration Works/Alamy

JOHN OLAGUES is owner of Truth in Options (www.optionsforemployees.com). Formerly a member of the Pacifi c Stock and Options Exchange and the Chicago Board Options Exchange, Olagues cofounded Options Research, the fi rst analytical service to provide theoretical options values to market makers and the general public. For years he was considered one of the leading options market makers in the world, having created many of the trading and hedging strategies used today.

JOHN SUMMA, PHD, is an author, economist, and founder of OptionsNerd.com. In 2001, Summa coauthored the Wiley title, Options on Futures: New Trading Strategies. A former fund manager, he recently launched the ESO educational Web site, HedgeMyOptions.com.

“Anyone who has been or is about to be granted stock options will fi nd this book extremely valuable.”—BLAIR HULL, Founder of the Hull Group, and current Chairman and CEO of Matlock Capital, LLC

“John Olagues and John Summa have made an important contribution for guiding employees and service providers in managing their employee stock options, written from the perspective of the options trader. The basics of defi ning the various elements of risk and approaches to managing employee stock options are clearly explained here for the beginner. This book provides practical strategies to be implemented with the guidance of skilled tax, legal, and investment advisors.”

—MICHAEL GRAY, CPA, author of Secrets of Tax Planning for Employee Stock Options, 2009 Edition

“This book provides a much-needed introduction to practical hedging strategies for employee stock options. Filled with concrete examples and detailed explanations, it reveals the importance of optimal hedging and exercise timing in ESO management.”

—TIM S. T. LEUNG, Assistant Professor, Applied Mathematics and Statistics, Johns Hopkins University

“This is the most comprehensive text I’ve seen on employee stock option strategies. If you want to understand the alternatives for your options, this is a must-read.”

—CHRIS MURPHY, ESO Expert, Credit Suisse

“I can’t believe this book has not been written before. Employees and executives have been letting wealth evaporate for years because they did not realize the value of their stock options. Here, the authors educate the employee on the value of their option holdings and give a sound strategy for maximizing profi ts.”

—TOM McGOURN, CFA, Derivatives Valuation Consultant, Montgomery Investment Technology, Inc.

PRAISE FOR

GETTING STARTED IN EMPLOYEE STOCK OPTIONS

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Getting Started in

EMPLOYEE STOCK

OPTIONS

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The Getting Started In Series

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Getting Started In Bonds, Second Edition by Sharon Saltzgiver Wright

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Getting Started In Employee Stock Options by John Olagues and John F. Summa

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John Olagues

John F. Summa

John Wiley & Sons, Inc.

Getting Started in

EMPLOYEESTOCK

OPTIONS

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Copyright © 2010 by John Olagues and John F. Summa. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in

any form or by any means, electronic, mechanical, photocopying, recording, scanning, or other-

wise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act,

without either the prior written permission of the Publisher, or authorization through payment

of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive,

Danvers, MA 01923, (978)750-8400, fax (978) 646-8600, or on the Web at

www.copyright.com. Requests to the Publisher for permission should be addressed to the Per-

missions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)

748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best

efforts in preparing this book, they make no representations or warranties with respect to the ac-

curacy or completeness of the contents of this book and specifically disclaim any implied war-

ranties of merchantability or fitness for a particular purpose. No warranty may be created or

extended by sales representatives or written sales materials. The advice and strategies contained

herein may not be suitable for your situation. You should consult with a professional where ap-

propriate. Neither the publisher nor author shall be liable for any loss of profit or any other

commercial damages, including but not limited to special, incidental, consequential, or other

damages.

For general information on our other products and services or for technical support, please con-

tact our Customer Care Department within the United States at (800) 762-2974, outside the

United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in

print may not be available in electronic formats. For more information about Wiley products,

visit our Web site at www.wiley.com.

ISBN-13: 978-0-470-47192-0

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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To Caroline and Christine Olagues . . . . . my Beautiful Daughters, who are alwayson my mind

and my friend and helper Susan Naughton

For Kelemua

and Wondifraw Summa, two amazing and wonderful kids

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vii

Contents

Preface xi

Acknowledgments xv

Chapter 1

Introduction 1

Chapter 2

Preliminary Concepts and Definitions 5

Chapter 3

Options Valuation and Basic Concepts 15

Chapter 4

Risks of Holding ESOs (Unhedged) 27

Chapter 5

Tax Consequences of ESOs 31

Chapter 6

Straddle Rule and Tax Implications of Hedging ESOs 37

Chapter 7

Management of ESOs and Premature Exercises 45

Chapter 8

Comparison of Premature Exercises with Early

Withdrawal from IRA 53

Chapter 9

Strategic Choices for Managing Your ESOs 57

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Chapter 10

Basic Hedging Strategies Overview 61

Chapter 11

Constraints on Hedging: Real and Imagined 75

Chapter 12

Premature Exercise: Pros and Cons 87

Chapter 13

Putting It All Together: The 7 Percent Solution 91

Chapter 14

Does Hedging ESOs Undermine Alignment of Interests? 103

Chapter 15

Why Do Companies Want You to Exercise Prematurely? 107

Chapter 16

ESO Hedging Case Studies 111

Chapter 17

ESO Valuation Methods 127

Chapter 18

Comparing Restricted Stock with ESOs 129

Chapter 19

Google Transferable Options 133

Chapter 20

Introducing the New World Options Plan 139

Chapter 21

Understanding Executive Abuses l 149

viii CONTENTS

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Chapter 22

Understanding Executive Abuses II 153

Chapter 23

Understanding Executive Abuses III 157

Appendix A: IRS Tax Implications of Hedging ESOs under IRS

Sections: 1221, 1259, 1091, 1092 165

Appendix B: Did the SEC Encourage Backdating

and Spring-Loading? 181

Glossary 185

Index 195

Contents ix

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Preface

stimates have been made that there are 10 million employees andexecutives in the United States, and millions more worldwide, whoown employee stock options (ESOs). For a significant number of

these employees and executives, ESOs constitute asubstantial portion of their financial assets, and thustheir net worth. Since holders of ESOs do not havethe choice of selling these assets in a liquid market,as one might do with exchange traded options tolock in gains or reduce potential for losses, a plan foreffectively managing ESOs over the long run mustbecome the most prudent course of action.

Yet few employees and executives holdingESOs truly understand the actual and potentialvalue of these assets. For these individuals, this bookpresents both a valuable source of accurate ESOinformation and, most importantly, the necessarytools for managing these wasting assets. The con-cepts and strategies explained in this book will allowgrantees (holders) of ESOs, and their financial advi-sors, to optimize management of ESOs, and toavoid the common pitfalls. The grantee will thus bein a better position to maximize the value of his orher ESO holdings, while effectively managing ESOrisk and tax liabilities.

This book, however, differs in at least one cru-cial aspect from others written on the subject. Inthis book, the reader will find strategies fullyexplained, including detailed case studies, involvingthe selling of exchange-traded (listed) calls and buy-ing of exchange-traded (listed) puts, which areaimed at hedging the risk of holding ESOs while max-imizing their potential value. As is demonstrated

xi

EEmployee Stock Options(ESOs)

ESOs are contracts

between the

employee (or

grantee) and the

employer (or

grantor) that give

the employee the

right, but not the

obligation, to

purchase common

stock from the

employer for a

specific price for a

specified period of

time. The expira-

tion date is fixed

on the grant day

but may change if

the employee

decides to termi-

nate or is termi-

nated earlier than

expiration. The

expiration date is

generally ten years

from the grant

date.

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throughout the book, use of exchange-traded options is the best (andonly) method available for efficiently and effectively achieving risk reduc-tion while preserving and potentially enhancing the ultimate value ofESOs.

Typically, wealth managers and investment advisors and their taxaccountants will recommend as a risk reduction plan the premature exerciseof ESOs and sale of stock acquired by the exercise. A profit would typicallybe realized with the exercise of the ESOs and the sale of the stock. An advi-sor would probably encourage the use of the net proceeds to diversify intomutual funds and an assortment of stocks, while perhaps keeping some stockin the company for which the grantee works. This can be a costly move.

Imagine yourself owner of Google ESOs that were granted givingyou the right to purchase 1,000 shares of Google at a price (strike price)of $300. Now fast-forward two years and the ESOs are vested. You exer-cised and sold the stock at $650, taking the net after-tax proceeds andinvesting in a diversified stock or mutual fund portfolio. Your gain wouldlook something like $350 per each share of stock, or $350,000. But youwould pay 40 percent of that in ordinary income taxes, leaving $210,000in net gains after tax.

Given the declines across the board in the past year (2008), how-ever, you could have been down as much as 50 percent, depending onwhere you parked your money. Suppose your losses on the diversifiedinvestment amount to minus 45 percent. This means that your diversi-fied investment portfolio is now worth just $115,500. The $115,500would then represent less than 30 percent of the “fair value” of the ESOson the day you exercised them. You paid $140,000 in compensationincome tax and forfeited $36,000 of “time premium” when you earlyexercised. Not a pretty picture, but a move taken by many ESO holdersper advice from traditional wealth managers. Had you simply held ontoyour ESOs and bought some puts to hedge them, however, you wouldhave come out much better.

With some simple hedging using listed puts and calls inside or out-side of an individual retirement account (IRA), you could have avoidedmuch, if not all of the large losses from the market decline hurting yourportfolio and the payment of premature taxes. Even having hedged the ESOs, you would still have had potential for large upside gains. Thehedges would have offset a large degree of the unrealized losses on theESOs resulting from declines in the market for Google stock. For exam-ple, you could have made tax-free money on the puts, which would offset losses in theoretical value of your ESOs.

xii PREFACE

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Yet the ESOs you would still hold would have potential for recov-ery along with additional hedging for further premium capture throughcall selling. The difference in traditional management approaches and ahedging approach is like the difference between driving a 1950s autowithout wearing seat belts and driving a late-model auto with seat beltson and airbags operational. You should get the picture. Old fashion ismore than old—it is misguided and potentially very dangerous, finan-cially speaking.

In our view, informed ESO hedging with exchange-traded optionswill lead to far superior outcomes than use of any other strategy currentlyoffered by wealth managers and financial advisors. With the publicationof this first-of-its-kind book, those superior outcomes are now in reachfor most ESO holders.

Preface xiii

The Big Picture

The difference in traditional ESO management approaches and an ESO

hedging approach is like the difference between driving a 1950s auto

without wearing seat belts and driving a late-model auto with seat belts

on and airbags operational.

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