A lot of employees these days are paid in the form of stock options or shares directly. A friend of mine recently took a job where he will be paid a substantial sum in shares one year from now. The dollar value of those shares today is quite a lot of money. But he’s worried about a serious downturn, in which his shares will be worth significantly less. I suspect that privately, he would rather have simply been paid the equivalent value in cash. Of course he can’t air that publicly, accepting stock is a gesture of confidence of the company.
So how can my friend get paid in stock, but also reduce his exposure to its volatility? He can use stock options.
Let’s say that he’s receiving Apple Stock (he’s not, it’s just an example). For the sake of argument, let’s say he’ll receive 100 AAPL shares on exactly June 17th, 2016. AAPL shares currently cost $126.75 each, so 100 shares are worth $12,675. Let’s ignore taxes for the sake of simplicity (usually a dangerous assumption). My friend, let’s call him Simon, can buy an AAPL put to protect him against downside risk. He could buy an AAPL put at $125 a share expiring on June 17th, 2016. This currently costs $11.65 per share, or $1165. This gives him full downside protection for an entire year. Still, it’s quite expensive, amounting to 9% of the value of the shares. If Simon still believes that AAPL could rise, but is also fearful of a crash, buying a put only, at high cost, may be logical. Note that it is not irrational to both be fearful of a crash and optimistic of a rise; that’s merely a bet against the status quo. But in any case, buying the downside protection for 9% of the underlying shares is expensive.
But what if Simon wants utter certainty? What if he wants the equivalent of guaranteed cash? Simon could both buy a put and sell a call. This means he has downside protection and has yielded his claims to any future upside. A call at $125 expiring on 6-17-2016 sells for $12.75 per share, or $1275 for 100 shares.
If one buys a put and sells a call while holding the underlying shares, one has entered into a collar options position. This is a roundabout way of defusing one’s exposure to shares while still owning the shares.
Buying a put and selling the call will give you a net position of $12.75 – $11.65 = $1.1 per share. Since we chose a strike price of our options at $125, but the current price is $126.75, we are implicitly forfeiting $1.75 per share. This was reflected in the higher price we fetched for the call option. So let’s account for this:
$1.1 – $1.75 = -$0.65 per share.
This is the actual price for hedging against volatility in AAPL shares for the next year. It’s about 0.5% of the cost of the underlying; it’s actually exceptionally cheap. You won’t collect dividends because the underlying shares are being held by someone else in the interim.
If you quit your job early and don’t get awarded the shares, you become exposed to an upward movement in the share price. In effect, you will have sold a call that you can no longer cover. Most brokerages won’t let you do this unless you actually have the shares under their management; they don’t want clients getting unduly exposed. So a safer way to actually do this is, instead of selling a single call, sell a bear call spread.
In the case of AAPL, instead of only selling a call at $125, we could additionally have bought another call at $150 for a relatively cheap $4.25. This would protect us, if we got fired and did not actually receive the underlying shares, a massive AAPL price movement to $200 a share would not hurt us. We would only have to pay for any difference between $125 and $150. Paying $4.25 per share hurts our costs though, making us pay -$0.65 – $4.25 = -$4.9 per share. This is now about 3% of the underlying. We also need to hold ($150-$125 ) * 100 = $2500 idle in our brokerage account to cover the call spread we sold.
Although it sounds tedious, it’s still an extremely safe way to hedge against stock grants. Best yet, Apple will have no way of knowing that Simon, the loyal employee, is secretly hedging against a decline in its price. Thus he can publicly embrace his faith in the company, while privately protecting himself. In the mean time, he’ll have translated volatile stock grants into guaranteed cash.