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Employee Stock Options

The tech explosion of the late nineties created a new class of wealth. In addition to entrepreneurs, venture capitalists and top level executives, a large number of mid level executives, technicians and support personnel through hard work, long hours and faith in the future of technology received stock options with or in lieu of salary. Employees often used their shares of stock to realize their dreams of retirement, paying off mortgages and financing new business ventures.

Employee shareholders were often directed by their employers to a full service brokerage firm for the purpose of exercising their options on a "cash" or "cash less" basis. Unfortunately, many suffered damages as a result of poor supervision and/or inexperience of the brokers handling the exercise transaction as well as post-exercise management of the portfolio.

Following the exercise, people found themselves holding a paper fortune in a single stock and they turned to the brokerage firms for help. Diversification of a single stock position is the simplest way to reduce risk, but is not always the best option. In some instances, employees received shares of restricted stock which could not be sold for a period of time. Other shareholders wanted to qualify for or defer capital gains taxes. Still others wanted to hold concentrated stock positions because brokerage firm analysts were bullish on the particular stock.

No matter what a customer's financial objectives are, a brokerage firm owes its customer a fiduciary duty which includes the disclosure of information about the different ways a position can be hedged to protect the value of a life's work delivered to a full service brokerage firm for professional advice.

One of the most popular strategies is a "zero cost collar," where a put option is purchased and call options are sold. The money raised from selling the calls pays for buying the puts. This will normally allow the customer to sell the stock at 85-90% of current value if the price drops and requires a sale at approximately 115% if the price increases. While this hedge does not cost anything, the trade off is capping the growth potential of the stock.

For someone who believes in the upside potential of a stock, but wants protection from a price drop, purchasing put options may be the best course of action. These purchases can be financed by margin if there are no other funds available.

A prepaid forward sale (also known as a "variable delivery forward") is a hedge where an investor agrees to sell the stock in two to five years, but receives 75-85% of the current value up front. At the end of the contract, either the stock or the cash equivalent can be delivered.

Another benefit of these hedging strategies is that they may not trigger a taxable event since they usually are not classified as an immediate sale.


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