1. Summary
  2. Write Calls
  3. Buy Puts
  4. Costless Collar


Basic ESO hedging methods embrace writing calls, shopping for puts, and constructing free collars. of those methods, writing calls is the just one wherever the erosion of your time price in ESOs is often offset by obtaining time decay operating in one’s favor. we tend to powerfully suggest that you simply discuss any hedging methods together with your monetary planner or wealth manager.

We use choices on the hypothetic XYZ house., to demonstrate hedging ideas. Say that XYZ closed at $175.13 on Nov fifteen, the date at which period the longest-dated choices out there on the stock are the three-year calls and puts.

Let’s assume you’re an XYZ worker who is granted ESOs to shop for five hundred shares of the corporate on Nov. 29, which can vest in 1/3 increments over the future 3 years, and have ten years to expiration. For reference, the three-year $175 calls within the market are priced at $32.81 (ignoring bid-ask spreads for simplicity), whereas the hundred seventy-five puts trade at $24.05.

Here are 3 basic hedging methods, that supported your assessment of the stock’s outlook. to stay things easy, we tend to assume that you simply want to hedge the potential 500-share long position to simply the past 3 years.

Write Calls

The belief here is that you simply are neutral to moderately optimistic on XYZ, within which case one risk to induce duration decay operating in your favor is by writing calls. whereas writing naked or uncovered calls are often a really risky business, during this case your short decision position would be lined by the five hundred shares you’ll be able to acquire through the exercise of the ESOs. You so write 5 contracts (each contract covers a hundred shares) with a strike value of $250, which might fetch you $10.55 in premium (per share), for a complete of $5,275 (excluding prices like commission, margin interest, etc.). If the stock goes sideways or trades lower over future 3 years, you pocket the premium and repeat the strategy when 3 years. If the stock rockets higher and your XYZ shares are “called” away, you’d still receive $250 per XYZ share, that at the side of the $10.55 premium, equates to a come of just about five hundredths. (Note that your shares are unlikely to be referred to as away well before the three-year expiration as a result of the choice client wouldn’t want to lose duration through early exercise). Another difference is to write down one decision contract one year out, another contract 2 year out, and 3 contracts 3 years out.

Buy Puts

Let’s say that though you’re a loyal XYZ worker, you’re a small indefinite quantity pessimistic about its prospects. This strategy of shopping for puts can solely offer you drawback protection, however, won’t resolve the time decay issue. you think that the stock may trade below $150 over the future 3 years, and thus obtain the three-year $150 puts that are out there at $14.20. Your outlay during this case would be $7,100 for 5 contracts. you’d reach if XYZ trades at $135.80 and would create cash if the stock trades below that level. If the stock doesn’t decline below $150 over 3 years, you’d lose the complete $7,100, and if the stock trades between $135.80 and $150 by then you’d recoup a part of the premium paid. This strategy wouldn’t need you to exercise your ESOs and may be pursued as a complete strategy additionally.

Costless Collar

This strategy allows you to construct a collar that establishes a commercialism band for your XYZ holdings, at no or minimal direct value. It consists of a lined decision, with half or all of the premium received won’t to obtain a place. during this case, writing the 3-year $215 calls can fetch $19.90 in premium, which may be wont to obtain the 3-year $165 puts at $19.52. during this strategy, your stock runs the danger of being referred to as away if it trades higher than $215, however, your drawback risk is capped at $165. Of these methods, writing calls is the just one wherever you’ll be able to offset the erosion of your time price in your ESOs by obtaining time decay operating in your favor. shopping for puts aggravates the difficulty of your time decay however could be a sensible strategy to hedge drawback risk, whereas the free collar has minimal value but doesn’t resolve the difficulty of ESO time decay.