Listed Options & Dealing with Equity Compensation Concentration Risk
The narrative of equity compensation causing dangerous concentration risks for employees is far too common in today’s business world. Between NSOs, ISOs, RSUs, and other forms of equity compensation, many employees find themselves in positions where their company’s stock makes up over 30% of their liquid net worth – this leads to an immense concentration risk!
Since I have been heavily involved in this industry for most of my career, finishing the CFA (Chartered Financial Analyst) program almost 18 years ago, I am all too aware of the dangers of concentration risk. On the positive side, concentration does not only build wealth quickly, but it can even have the potential to make you “rich.” But with this potential return also comes a risk that can quickly destroy wealth and riches. Twenty years ago, General Electric (GE) was “the pinnacle of the American economy.” At the time, if there was ever a company to be concentrated in, it was GE. We are all aware of GE’s fall from greatness: GE even felt the need to perform a reverse split, and strong companies rarely implement reverse splits.
One concentration-risk solution for many employees is using listed or exchange-traded options. While these are similar in some ways to equity compensation options like NSOs (Non-Qualified Stock Options), they are dramatically different.
Before using any listed option hedging strategy, you should make sure you understand how they work and what the possible outcomes are for each respective strategy. All of the strategies mentioned here can have tax and regulatory consequences, including but not limited to affecting capital gains holding periods, changing how dividends are taxed, constructive sales rules, and company restrictions on hedging. Specifically, ISOs (Incentive Stock Options) have more complex rules surrounding disqualifying dispositions and will therefore not be discussed here, but in future posts. Please consult your financial or tax professional before acting on these strategies.
The goal for any hedging strategy is to eliminate some or all market risk.
There are four main circumstances where using listed options can be appropriate:
1. Hedging non-vested RSU and RSA market risk
2. Hedging non-exercised NSO market risk
3. Hedging existing company shares
4. Producing income to offset market risk and tax costs
Below, I will discuss how short calls and long puts (listed options) are employed in each of these scenarios.
Scenario 1 & 2
The first two scenarios are very common. An employee can often have several different forms of equity compensation, all with value or a perceived value yet the employee may still not have access to the actual shares. We are all human, so it is natural that employees mentally count the value of their equity-comp statements as part of their net worth. However, this valuation becomes dangerous when employees often begin making plans around this value, or their perceived future value. For example, here in the Brainerd Lakes area of Minnesota, there has been a frenzied rush for lake property. It is a rarity if properties remain on the market for more than a day, and offers come in at tens of thousands of dollars over the asking price – it is simply crazy! As you may guess, some of the culprits responsible for this real estate boom are cheap money, high 401k balances, and work-from-anywhere culture. Importantly, though, equity compensation is also at least somewhat responsible for this frenzy.
One person I spoke with, we will call him Bob, paid $50k over ask and 43% more than the property value just a year prior. When I asked Bob why he was willing to overpay so significantly for the property, he told me that he had some NSOs he was planning on exercising soon, which would more than cover the overpay. However, there is an important problem with his reasoning: he was making this decision based on the current market value of his stocks. What would happen if the stock drops in price?
This is where options can come into play. Let’s examine a case study where our friend, Lake Life Bob, works for Caterpillar and owns the following assets:
· 1000 NSOs to buy ticker symbol CAT at $50 (current market price $200)
· 500 RSUs that will vest next year, in 2022
People who are familiar with equity comp know that this employee does not get the actual shares of stock from the RSUs until they vest. So, if Bob is counting on using the $100,000 from the RSUs based on the current market price, he will be very disappointed if the price of CAT drops to $100 and the stock he receives is now only worth $50,000, especially if the affordability of that sandy-beached dream house with a perfect walleye spot within a five-minute boat ride depends on it.
The same holds true for the NSOs. Bob may not be able to exercise them yet because they are not vested, he may not want to exercise them now because it is a high-tax year, or he may wish to leverage the growth available with NSOs.
Regardless of the reason, many employees end up with market risk that needs hedging. In this example, Bob is planning on buying real estate while relying on the idea that he will earn $250,000 (remember, Bob must pay $50 per share for the 1000 shares – the strike of the NSOs) in Caterpillar stock next year!
One of the best ways to hedge the risk for short-term timeframes is to buy Puts. Puts are a type of option that gives the holder the right to put (sell) the stock to someone else at a specified price. It is like buying insurance. And, like insurance, you must pay for them. And, if you do not use them, you will most likely lose them. Unlike your homeowner’s insurance, you do have the option to sell Puts.
Here is what this might look like for Bob, who wants to spend his mornings in Nisswa, MN drinking coffee and eating scones at Stonehouse, his days’ waterskiing with the kids on Pelican Lake, and his nights at Bix Axe Brewing having a pint with friends.
He could buy (go long) 15 contracts of January 2022 Puts with a strike of 200. This contract is often called an at-the-money Put since the strike price is the same as the current market value. (FYI – at-the-money and in-the-money Puts are more likely to have negative tax consequences). This purchase would give him the right to put (or sell) 1,500 shares of CAT to someone at a price of $200, giving him the $300,000 gross funds he is counting on. The cost to do this is $10 per share, or $15,000. (While this example is purely for us to learn the concept, this price is very close to real life. Still, option prices can vary significantly based on many different variables, so I would not get too hung up on these numbers.)
While this “insurance” is not cheap, you can see how, if the employee is counting on the company’s stock price to remain at a certain level, this option will achieve that goal for limited timeframes. In our above example, the right to sell the shares expires in January. Also, keep in mind that there is no limit on the price appreciation, meaning that if CAT stock climbs to $300 a share, the employee participates fully in this increase, minus the cost of the Puts. The graphic below may help visual learners, like me, better internalize this concept:
As time passes, the Puts’ value will primarily be dictated by CAT’s stock price. At any point before expiration, the employee can sell the Puts for a profit or loss. If CAT’s stock price is at or above $200 come January, the Put’s value will be $0. If CAT’s strike price is below $200 (the Put is in-the-money), then the Put’s value will be the strike price minus the market value (the intrinsic value), plus any time value left.
Most people in this scenario will sell the Put if it is worth anything as it approaches expiration since they do not have the shares to deliver. Remember that we bought the Put insurance for the NSOs and RSUs because we did not have the shares to sell. RSUs must vest to sell, and NSOs must be exercised to get the shares.
While buying insurance with a Put is a perfect risk mitigator for many people in Scenarios 1, 2, and even 3, sometimes there is a need to produce income or reduce the cost of the Put insurance. You can fulfill this need by writing (selling) Covered Calls, also known as being short the Call.
The Covered Call
Recall that, when we bought the Put, we purchased the right to do something: the right to sell our shares to someone else at a certain price. Now, by selling a Call we are selling someone else the right to do something: the right to buy shares from us. The owner of the Call has the right to purchase our shares at the strike price. And, as you may suspect, the other party would only exercise their right if the stock price rises above the Strike price.
For our example, we will assume that the employee sold a January 2022 Call with a strike of $250 for $10. Because the employee is the seller, they will receive the premium, which is $10 in this case. That is how employees can produce an income using their options. This income could be used to offset some tax liability or reduce financial risk. Going back to our graph, you can see that writing Calls does not have the same downside protection as a Put. The downside with a Call is the current market price of the stock minus the premium received from selling the Call because the stock could decrease to zero. Therefore, the downside with the Put is the strike price minus the cost.
The biggest reason why many clients do not like Covered Calls is that their upside is limited. If the stock price rises to the moon, the shares will certainly be called away. If you write Covered Calls, you must be comfortable giving up the shares at the chosen strike price.
Another issue with writing Covered Calls is that they most often must be covered (as the name suggests), meaning that you actually have to own the shares before writing them. As I mentioned before, if you own NSOs or RSUs, these are not yet actual shares of stock. And, even if you do have shares delivered because of your equity comp, they could be locked up with your company’s custodian. External brokerage houses will not recognize these shares as eligible for writing Calls. If you do not have the shares, the written Calls would be classified as Naked. There are very few things riskier than Naked Calls, and their downside is almost unlimited. If the stock rises to the moon, you will suffer losses all the way up, minus the premium you received from selling the Calls.
As the stock rises, the brokerage house will not let the paper loss continue forever. There are Margin Requirements in place which could force the client to close out the position or bring in more cash, locking in the losses. Like our discussion of the tax implications of hedging, we do not have time to get too far into how Margin works, but I suggest you handle any trading done on Margin with care.
The Zero-Cost Collar
At this point, you may have already synthesized the Put and Call together and predicted our next tactic: the Zero-Cost Collar. This strategy uses the proceeds from the Call sale to pay for the Put, thus creating the Zero-Cost (Costless) Collar. Building upon our previous examples, the diagram for the Collar would look something like this:
If the Put and Call each cost $10, the prices cancel each other out, and this hedge is costless. If the stock drops, the Put ensures that the employee will get $200; if the stock climbs, the employee participates in the gain up until a value of $250, at which point the shares would most likely be called away. Assuming that the tax and constructive sale implications play a relatively small factor, this strategy could be a great option (pun intended) for our lake-country wannabe. As always, Collars are a complicated strategy, so please consult a financial professional before using a Zero-Cost Collar.
Before selecting any hedging or diversification option, be sure to investigate all of the potential choices. In future blog posts, we will cover many of these strategies, including, but not limited to, Exchange Funds, Donor Advised Funds, Prepaid Variable Forwards, and Stock Protection Trusts.