I have many clients employed by publicly traded Fortune 500 companies. When my clients begin their careers, their compensation plans are normally composed of a base salary with performance-based cash bonuses. As my clients progress through their careers into departmental supervisory and managerial roles, compensation bonus payouts generally tend to become more complex by involving the use of stock options and stock grants as a measure to incentivize their department’s contribution to both short-term and long-term financial success of the firm.
As a seasoned financial advisor, I advise many employee’s along all aspects of the value-add spectrum of many Fortune 500 companies. Throughout my experience, an interesting paradigm has presented itself. Many employees hold company stock in large concentration and may not divest because their fortunes are tied to their efforts and those of their colleagues within their firm. I have found that many employees view the accumulation of company stock as a growth hedge designed to outpace the rate of growth of their diversified investment savings.
I have seen many employees grow their wealth exponentially because more of their compensation over their career becomes skewed toward stock grants and less toward cash bonuses. Their pool of wealth can grow faster in risky, concentrated stock holdings than in a diverse portfolio, where unsystematic risk is mitigated through diversification. While security specific risk of the pool of stock grants flies in the face of the basic tenets of diversification, the employee does have an incentive to maintain the concentrated company stock position. The receipt of dividends also complicates the matter because the dividends can be reinvested into the company stock, with potential to grow at high rates of return. Thus, many employees become over-invested in their company stock and have no plan to reduce the exposure of their wealth as they get closer to retirement. A shift in the fortune of their company can have a disproportionate negative impact on their portfolios.
One possible solution is to use an options contract strategy called a “No-Cost Collar” or a “Costless Collar”. The Collar Strategy protects an employee from the potential downside of a individual stock, while still providing the employee with access to realize the potential upside of the stock. By selling a call option (the right to buy stock) and by buying a put option (the right to sell stock), an employee can peg their area of maximum loss and maximum gain based on the strike prices of the options tied to the underlying stock. The strike price is the price at which the option contract becomes executable. The concept is called an option spread trade. However, unlike most spread trades which result in either a net debit or credit to the trader, the “Collar” is designed to be established at no cost to the investor. This is accomplished by buying an out-of-the-money put contract (a put contract with a strike price below the current stock price) and by selling an out-of-the-money call contract ( a call contract with a strike price above the current stock price). When the investor sells a call option contract they take in cash for selling the call option contract, which pays for the purchase of the put option. This spread transaction ensures that if the stock price were to fall below the strike price of the put option, the employee would be able to sell the shares at the strike price. If the employee executes the put option then the stock gets sold and the employee can close out the written call option contract for a lower premium than they received. If the stock were to appreciate above the call option strike price, then the investor would sell the stock at the strike price and take a profit. The put option would be able to be closed out and sold. The purpose of the “Collar” is filled no matter which direction the stock price ends up by the maturity of the options contract and is considered a viable strategy to hedge then uncertainty of a concentrated stock position. See the various points illustrated within the diagram posted below.
Investing into options contracts is a complex process and requires a detailed understanding of the characteristics of investing into the options markets. In some cases, there are structured products that are offered by financial advisors to automate the process of hedging concentrated stock positions. Our firm provides access to such structured products and if necessary can coordinate with your companies’ counsel and regulatory requirements regarding the use of hedging products for corporate insiders and officers.