By Libby Dubick, President, Dubick @ Associates
For many high net worth individuals, including senior executives, company stock or stock options are a key component of their compensation package. While accumulating stock in a growing company has created wealth for many investors, it can also create risk when it results in a concentrated position. Typically a concentrated position is any single holding which constitutes 10% or more of an investor’s portfolio.
Selling the position may not be possible. The stock may be in lock-up—a period during which new issues cannot be sold—or an executive’s contract may prohibit or limit his or her ability to sell. Some managers may believe that selling their company’s stock would send the wrong message to shareholders or the marketplace.
There could also be tax ramifications with a sale which an investor may want to avoid. “For example, the stock may have been acquired well below the current price,” explained Philip Gocke, Managing Director of The Options Industry Council (OIC). “While the executive would have a tidy gain on the stock, he would end up facing a big tax bill as well.”
Consider a Collar
An alternative to selling a position is isolating it from investment risk through the creation of a collar which locks in the stock’s current price by the purchase and sale of offsetting positions. One of the simplest ways to create a collar is through options; the stock owner writes a covered call on the security while purchasing a protective put.
A call option gives the owner the right, but not the obligation to buy the underlying security at the strike price on or before the expiration date. In turn the seller of the call is required to sell the security at the strike price at the buyer’s request. With a covered call the call writer already owns the equivalent number of shares of the underlying stock and is therefore “covered”.
Conversely, the purchase of a put gives the owner the right, but not the obligation to sell the underlying security at the strike price on or before the expiration date. In this case the seller is required to buy the security at the strike price at the put buyer’s request.
Usually the put and call have the same expiration month, are the same size, and are both out-of-the-money. Out-of-the-money options have no intrinsic value and are valued only by the prospect of becoming in-the-money sometime in the future.
Generally put and call options move in opposite directions. Call options usually rise in value as the underlying market prices go up. Put options usually rise in value as the market prices go down but time decay (the loss of value as the option moves closer to expiration) and change volatility also have an effect on pricing.
With a collar or spread strategy, risk is mitigated, but so is the opportunity for potential gains. “The investor can protect the downside without having a tax event,” said Phil Gocke. “The investor can remain long the stock---unless the market declines significantly and the put is exercised, which is a taxable event. Alternatively,” he added, “the investor can capture the put gain by selling the put prior to expiration (potentially a taxable event but on a much smaller scale) and still maintain the original stock position.”
Case Study
The CEO of National Widgets has 10,000 shares of National Widget stock. Today the share price is $50. To protect the current price he does the following:
- Buys puts at $45 for $10,000 (which means he is “self-insuring” for $5, the difference between the current market price of $50 and the $45 strike price)
- Sells covered calls at $55 also for $10,000 that expire in the same month
This transaction would be called a zero cost collar if the cost of the puts and income from the calls are the same. In essence, the collar sacrifices profit above the call strike for downside protection below the put strike.
If the cost of the put was less expensive to buy than the call was to write, he would be establishing a credit collar. On the other hand, if the put was more expensive to buy than the call is to write, it is a debit collar.
As with stock transactions there are commissions and fees charged for the execution of these trades. The amount varies by firm but there is a charge for opening a position and closing a position, and in the case of collars there are two legs to the transaction; the put and the call. Investors sometimes view these costs the same way they view paying for insurance— a nuisance if the insurance is not needed and well worth if it is.
The chart below illustrates the transactions.
Options At Expiration
For this strategy the optimum outcome is a rise in the stock price to exactly the call strike price. At that point both the put and call options would expire worthless and the investor would keep his original position, now worth $55 a share. The cost of the put insurance was offset by the sale of the calls and there is no taxable gain on the $5 appreciation of the underlying stock.
If the stock price is above $55, the CEO may choose to sell some shares at the strike price (though this would be a taxable event). Alternatively, prior to expiration, he may go into the marketplace and close out the call position with a purchase of the same call he sold, and be left with the original long stock position. .
If the stock price is between $54 and $45—the strike prices-- the CEO would either let the put expire worthless, or sell it back, though it would be worth much less than he paid. He is left with his original stock and has spent a relatively small amount to insure the value of the stock from a large loss.
If the stock price is below $45 the put leg of the collar becomes profitable but the position as a whole has declined since the gain in the put will not fully offset the loss in stock price. Depending on his situation the CEO may sell some of the stock at the strike price he locked in, buy the stock back at the lower price or roll the position forward to maintain the $45 value of his position.
For More Info On Collars
OIC is an excellent resource for investors with questions about collars, or options in general. “Our mission is to provide options education and help individuals, advisors and institutions with their options trading,” said Phil Gocke. “We have a website at www.OptionsEducation.com where investors can take an online class, watch a webcast, try the virtual trading system, register for live seminars or explore audio and video podcasts.
“During business hours it is also possible to chat online with options experts or call the Options Help Desk at 1-888-OPTIONS for assistance,” he added. “Options offer CEOs a great tool to manage concentrated stock positions and protect the value of their portfolios.”
