Book Review: Getting Started in Employee Stock Options

John Olagues and John Summa put together an interesting book.  It's an important read if you own, or know people who own, employee stock options (ESOs).

Getting Started in Employee Stock Options explains that most recipients of ESOs  exercise far earlier than the option expiration date – to lock in profits.  As option traders, all of you know that this is discarding many dollars worth of time value.


Olagues


The two Johns provide much guidance is hedging (reducing the risk of owning) ESOs.  If you can avoid exercising prematurely, there's a high probability that you will come out earning extra dollars by the time you do exercise the options.  If you have been exercising, or plan to exercise some of your ESOs in the foreseeable future, read this book. It's worth your time.

If you have friends or family members who earn ESOs and if they don't understand options very well (or at all), get this book as a gift.  They may not need your help, but if necessary, you can guide them through the basic option concepts. 

The book offers a detailed explanation of how people can hedge their options by using exchange-traded options in the same underlying stock.  Tactics include selling calls and/or buying puts, and the authors recommend trading LEAPS (longer-term options)

Why bother with hedging?  It's an intelligent way to maximize gains from those ESOs.  It makes no sense to throw away thousands of dollars in time premium when there are suitable alternatives.

Unfortunately, if your options were issued by a small company that does not have its options traded on an exchange, then simple direct hedging is not available.

Concerned about tax consequences of your hedging trades?  This book has the answers.

Want to know why companies love it when you exercise early?  There's a thorough discussion. HINT: Early exercise forfeits remaining time premium, and that's a gift to the company.

If there's something you want to know abut ESOs, this book has it.  The authors are not shy, offering their opinions on topics of significance.  The bottom line is that this book is not for everyone, but if you are among those who receive part of your compensation in the form of employee stock options, don't miss this book.  

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14 Responses to Book Review: Getting Started in Employee Stock Options

  1. Michael James 06/24/2010 at 7:26 AM #

    The book sounds interesting. My own experience with ESOs tells me that there are other considerations that can affect decisions to exercise early or hedge. At my company, ESOs were illiquid in the sense that we could be hit with blackouts on exercising or trading at any time. These blackouts were typically a month or so long, but could be longer.
    Another problem was that ESO exercise was done through an organization that often failed to execute instructions. Requests were made by fax and these faxes were frequently ignored (and in one case, executed twice). Unlike typical trading, employees didn’t have the choice to find a better broker.
    Another consideration is that if things go very well, the built-in value in ESOs can grow to the point where they are a dangerously high percentage of the employees net worth. In this case it is worth giving up some time value to reduce exposure.

  2. Mark Wolfinger 06/24/2010 at 7:47 AM #

    Hi Michael,
    Yes, I agree.
    I know that it may feel wrong to exercise and lose that time premium, but if one is lucky enough to have a huge pile of unrealized profits, giving up some premium to exercise is just one way of insuring your money doesn’t get away.
    Depending on IV, it may be affordable to buy puts to protect those assets, and writing covered calls may offer solid protection – but I agree that in some situations it’s easy to exercise. Maybe John O. will offer his opinion here.
    And the employee may be able to work out a deal in which he/she exercises in exchange for a batch of new ATM ESOs. I’d settle for OTM options.

  3. Don 06/24/2010 at 7:55 AM #

    Mark, In your 33 years on the floor it seems as if you tried many different styles of trading before settling on IC’s and managing risk. I am curious as to your view of other successful traders that you saw managing their own money, not a firms. Did any of then develop stratagies that you thought were well planned? Didi they have a shared commonality- perhaps risk management? Who were the traders that kept their money and grew it over the long term? Nothing scientific just wondered what you expereince was seeing different styles of good and bad trading ideas.

  4. Mark Wolfinger 06/24/2010 at 8:08 AM #

    Don,
    I traded very differently as a market maker on the floor. I did not have the luxury of trading what I wanted. I made markets and took down whatever orders came into the trading pit. Sure on some orders, I traded as few as possible, but I never traded an iron condor in all those years.
    the majority of the safest traders used reversals (long calls, short stock, short put with same strike and expiry) and conversions (the opposite). Those are market neutral methods that had only two risks: A significant change in interest rates and pin risk.
    Their edge comes from buying stuff at bid prices and they tried to earn small amounts of money MANY times. We cannot do that from home.
    We did not discuss strategies with each other. Thus, I don’t know. But I know this: Those who did the best were those who recognized that safety was the prime consideration. There was money to be made, and not losing it was their top priority. I thought that I ‘knew better,’ took more risk, and had a very volatile account.
    Most traders played by being long extra puts and calls, so always had positive curvature (risk graph with a smile, not a frown). They may have lost money when premium shrank, but they were never on the wrong side of a big move. Never.
    I think the commonality was: as little risk as possible with zero exposure to a big move.

  5. Don 06/24/2010 at 11:25 AM #

    Thanks Mark, that is very interesting reading!

  6. John Olagues 06/24/2010 at 7:35 PM #

    Mark and Michael.
    As you know the ESOs have a value when they are granted even though people can not sell them, or place them in a margin account as good collateral for selling calls.
    But calls can be sold “naked” with the broker. The ESOs holder would have to advance cash or securities to hedge. At firms like thinkorswim, the initial margin for out of the money calls is about 10% of the value of the stock.
    We advise to start selling calls partially and increase the amount over time. This way, you maintain the alignment with the company and will still make a big score with an extreme move upward.
    I don’t believe that black-out periods are a problem.
    Its also possible to buy vertical puts spreads in IRAs to create negative deltas against your ESOs.
    Everything considered, that strategy may be the best way to go.
    Cheers:
    John Olagues

  7. Anna 06/24/2010 at 7:37 PM #

    This site looks helpful. I have always traded condors and trying a new style with butterflies.
    I made my first position this month and now scratching my head on how to get out. Put about $15k into a Jul 50/55/60 when stock was at 54.35 and now closing in on 51 and Im down $4000. Original debit was around $3. Internal volatility of stock was around 16.
    Having trouble finding much info outside of the basics of butterflies especially surrounding adjustments.
    Do you have any adjustment recommendations in this type of scenerio? In retro kicking myself for not reducing position size when trade went positive but …
    It looks as though most common “adjustment” is just closing down position completely which I’m trying to avoid if a more favorable escape exists. Would there be any validity to rolling bottom strike calls to upper strike and keeping shorts in place to salvage remaining credit? (not sure if that credit is referred to as theta or gamma).
    Or is there a more acceptable alternative that you may have come across in your experience. Some have mentioned turning into a condor but not really sure specifics of how that would work.
    Do you have any advice for this situation or could steer me to a good source on butterflies and position adjusting this style? Thank you for your time.

  8. Mark Wolfinger 06/24/2010 at 10:21 PM #

    John,
    My fear is taking losses in an IRA. Tax-wise, that’s just not a good thing to do.
    I’d prefer to trade put spreads in a regular margin account.
    Am I missing an important point?

  9. Mark Wolfinger 06/24/2010 at 10:46 PM #

    Anna,
    First piece of advice is to trade much smaller size with a new strategy. Unless you regularly trade condors in multi-hundreds of lots, I don’t believe it’s wise to buy 50-lots on your first trade with a new idea. Unless the risk/reward is very attractive.
    I’ve almost never traded butterflies. I note that this is a low volatility stock, but paying $3 for a butterfly is not going to work for you. One huge problem with these spreads is the trader must hold until near expiration to get a high credit. When you pay $3, there is no trading room. It’s not easy to get out for a trading profit – perhaps 50 cents (in case you decide to do that). I note that you passed on the chance to lighten up, but that’s in the past, so don’t let it bother you.
    To me a fly is a trade for which I pay about 50 cents and am wiling to sell for 3 to 4 times that amount. It is not a trade where one pays $3 and hope to get $4.50. But, as stated, I don’t trade these.
    Most of those who trade butterflys do so because they are so inexpensive to buy. That translates into a low risk/reward.
    As I said, this is not my playing field, but I believe buying ATM butterflys, hoping the stock doesn’t move much is already a difficult game. But paying $3 makes the chances of success pretty small.
    Anna I’d love to help, but I truly don’t know what to do to salvage this trade. It was a very low probability – high risk trade when you opened it. I don’t see what to do now.
    If you want to turn it into a condor, you would sell the 50/55 C spread, and then sell an OTM put spread to go with the short 55/60 C spread. But with a low IV stock, you won’t get anything for the put spread. Does not sound like a good risk to me.
    If you decided to sell out the 60s and buy more 50s, how would that ‘salvage’ anything? That places you at even more risk if the stock declines. That trade is possible, but it is a very bullish play – and your current position is already bullish. I don’t like this choice either.
    My belief is that you made a bad trade. However, that is 100% immaterial right now. Your decision is simply this: Hold ’em or fold’ em.
    If you want to take a bullish stance on this stock, then hold the fly. If you fear holding is too risky or you believe the stock is likely to decline, then I’d take the loss and find a better trade.
    I wish you good trading.

  10. Anna 06/24/2010 at 11:20 PM #

    Thanks. Didn’t mean buying more 50’s but rather opposite by dumping those and rolling half up to 60 to complete bc spread on 55 shorts.

  11. Mark Wolfinger 06/25/2010 at 7:04 AM #

    That choice sounds better to me. That does salvage the premium.
    Suggestion. The 60s are probably essentially worthless, so you may be better served to cover half the 55s when selling the 50s.
    Hope you make a winning decision. This one is not so easy.

  12. John Olagues 06/27/2010 at 8:46 PM #

    Mark:
    I think you can deduct the losses in an IRA under IRS Section 1092, whether you are hedging stock or ESOs. In fact you can deduct up to five times the loss. I hope the IRS is not reading this.
    The fact that the gains are surely tax free or tax deferred makes it such that you can do smaller positions and get the same after tax result as larger positions outside IRAs. Therefore, even if you can not deduct the IRA losses, your smaller positions give less after tax loss also.
    Also you never get a maintenance call for more margin after paying for the vertical put spread.
    John

  13. John Olagues 06/27/2010 at 9:23 PM #

    Mark.
    I believe it is possible to effectively deduct the put purchase versus the ESOs a an offsetting position under IRS Section 1092. Its a bit complicated. But I believe it can be done.
    Even if it can not be deducted, there is still advantages to buying the vertical put spread in the IRA because smaller positions are required to achieve the same after tax results and smaller amounts will be loss on the upside.
    John Olagues

  14. Mark Wolfinger 06/28/2010 at 7:56 AM #

    Thanks for sharing,
    I prefer writing covered calls to buying puts or put spreads.
    However, collars are another story, and I believe adopting a cost-free collar to lock in profits – and delay paying taxes – is a good idea.