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Options Trading vs. Employee Stock Options – What’s the Difference?

By: , dated February 22nd, 2012

Employee stock options have made employees at some companies instant millionaires. Companies such as Apple (AAPL), Microsoft (MSFT), and many other high tech firms have kept a good executive staff and a growing company thanks to awarding employees with participation in the ownership of the firm.

The main difference between options trading and employee stock options is the fact that options trading involves buying and selling options as a speculative endeavor, while employee stock options are generally used as a form of compensation that a company offers employees as an incentive.

Another major difference between the two is that employee stock options have no formal exchange listing and can only be exercised within the company on the stated terms that the company has provided the options under.

These terms include the price at which the employee has the option to buy the stock and how much stock the employee can purchase. Also, employee stock options sometimes have a time limit within which the options can be exercised.

Listed Stock Options

Listed stock options are typically highly regulated and very liquid derivative financial products with values linked to the price of the underlying stock, as well as other factors like the stock’s expected volatility.

This type of option trades on an exchange and can usually be exercised at the strike price by the buyer at any time during the life of the option. The buyer can also choose whether the option is an option to buy the stock, a call option, or to sell the stock, a put option.

Employee Stock Options

On the other hand, an employee stock option is typically issued by a company to its qualified staff as a bonus and involves the firm granting the employee an option for them to buy or call a specific amount of the company’s stock at a specific price. The stock can be the company’s common stock or an issue of restricted stock set aside for this specific purpose.

The company sets the amount of shares that can be bought using the option, the strike or exercise price and an expiration date for the option. Some employee stock options have no expiration date and can be redeemed by the employee at any time.

This gives the employee an incentive to make the company more successful, since the price of the company’s stock will generally rise if the company does well. Employee stock options make up an important part of many executives’ employment contracts, although companies can also extend employee stock option plans to their other staff members.

How to Trade Listed Stock Options Against Employee Stock Options

If the employee works for a large corporation that has its stock and options listed on major exchanges, then they may be able to sell listed options or stock against their employee stock call options that act as a hedge. An exception would be if the stock obtained from the exercise of an employee option is restricted so that the employee cannot to use it to cover a short position in the company’s common stock.

Also, before trading against their employee stock options, they need to be aware that selling naked options in an equity trading account may require a significant amount of money deposited as initial and maintenance margin. Since employee stock options are not a liquid derivative security, they are largely unregulated and cannot be used as collateral in an equity trading account to reduce margin requirements.

Since employee stock options are only call options, the employee could sell a listed call option with a higher strike price that is expected to expire worthless for some extra income. Alternatively, they could short the stock itself if they thought the stock was likely to decline and wanted to convert their employer-issued call option into a synthetic put option. They would also want to make sure that any listed call options they wished to sell expired before or on the same date as their employee stock option.

Jay Hawk Jay Hawk enjoyed a 12-year professional financial markets career incorporating extensive first hand futures and options experience obtained by trading in the stock, commodity and forex markets on U.S. exchanges. Since retiring as a full-time financial market professional, he has been actively trading stock, commodities, forex and options for his own account and managing funds for others, as well as writing financial market commentary and educational articles.

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One Response to “Options Trading vs. Employee Stock Options – What’s the Difference?”

  1. John Olagues says:

    Jay:

    I thought I was the only person promoting selling calls versus ESOs. You article is well written.

    Welcome to a very small but increasing group

    I hit the wrong star button and can’t change it.

    Lets communicate.

    John Olagues

    Here is an article I just wrote:

    Fiduciaries are required to advise efficient reduction of risk to holders of concentrated positions in employee stock options?

    In a paper by Craig McCann, a former school teacher, attorney and SEC official and Kaye Thomas, a tax attorney and author, we find them writing about how to handle your holdings of employee stock options.

    Essentially they say that after three years, when the options are vested, the optimal exercise time to exercise is when the stock is about 110% above the exercise price. They say that if the stock is 110% above the exercise or higher, you should exercise. If the stock is lower you should hold on until the stock goes higher.

    It reminds me of when Mark Twain was asked how to beat the market and he replied, “You buy ‘em and when they go up you sell ‘em. As far as the ones that don’t go up, you don’t buy ‘em”.

    Now most stocks will trade at a price between $70-$80 before they go above $110.

    In fact the chance of a stock starting at $50 and later (perhaps 3 years later after the vesting period expires) trading between $70-$80 is four times greater than the chance it would be trading between $110- $120.

    Now, fiduciaries have a a duty to try to reduce risk, especially when the investment holdings are in a concentrated position of company stock options.

    Lets assume that a person owned 10,000 vested ESOs to purchase the stock at $50 and there are 4.5 expected years to expiration. Now lets examine the risks associated with holding the ESOs when the stock is between $70-$80. If the stock drops 20% from $75 to $60 when expiration day arrives, the value of the ESOs are worth $10, which is down 70-75% from its value when the stock was $75 with 4.5 expected years to expiration.

    On the other hand, if the stock is trading for $115 and drops 20%, it would trade at $92 on expiration, making the ESOs with a $50 exercise price to be equal to $42 thereby losing $36 dollars (i.e. about 45%) of its value when the stock was $115.

    The chance of a 20% drop of the stock from $75 to $60 is the same as the chace of a stock with the same volatility dropping from $115 to $92.

    So the risk of large percentage losses are greater when the stock is $75 than if it were $115, both with a $50 exercise price. And the chance of the stock being near $75 is 300% greater than the chance of it being near $115 after 3 years.

    Therefore, it can not be denied that fiduciaries have a greater duty to reduce risk when the stock is near $75 than near $115. So why does McCann and Thomas, who call themselves “experts”, not warn fiduciaries to reduce risk when the stock is $75, having started from $50 on grant day.

    The answer is that the only way that risk can be efficently reduced is through selling calls and/or buying puts. The McCann, Thomas Strategy is not designed to illustrate an efficient way to manage risk, it is designed to benefit the wealth managers and the companies at the expense of the grantees. Perhaps that is the reason Thomas now works for Morgan Stanley.

    Early exercise, sell and “diversify” forfeits the “time value” of $92,000 and will net after tax about 60% X $250,000 = $150,000. But selling calls and/or buying puts delays the forfeiture of the remaining “time value” back to the company and delays or may eliminate the early cash flows to the company and delays or may eliminate possible assets under management to wealth managers.

    When all is said and done, if the holder of ESOs reduces his risks efficiently, it will reduce the grantee/company alignment accordingly but less so than early exercise sell and “diversify”.

    So there is a dilemma. Fiduciaries (i.e. wealth managers and financial advisers) have a duty to advise the reduction of the high risk of holding large concentrated positions in options on company stock. But at the same time they are looking to get assets under management.
    Unless the structure of the ESOs contracts are changed to eliminate this dilemma, it will always be there.

    So with help from Yingping Huang Ph.D. I decided to re-design the traditional contract to eliminate the dilemma and improve the contract for all parties…. the grantee, the company and the wealth managers, which doen’t require selling cals or buying puts.

    Its called Dynamic Employee Stock Options. See the link below:

    http://www.slideshare.net/OLAslideshare/desos-presentation-jan-03-2012
    ——————————————–
    I appreciate any comments on the new DESOs
    ——————————————–

    John Olagues
    504-428-9912
    504-875-4825
    olagues@gmail.com

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