September 8, 2010
Sam from Scarsdale, NY writes:
I own a lot of shares in my employer’s stock. I have friends who have lost a lot of money in bad situations and I have some concerns. Is there anything I should do?
First, separate the vested stock from the shares that are unvested. With employer stock (not options) of a public company it is generally a good strategy to sell vested shares at the time of vesting to diversify your portfolio. The exception to this would be if the size of your position in your company is small compared with your overall investment portfolio so as not to create a concentration risk. Please be aware that there may be restrictions on when and how you sell your shares, even if they are vested. It is always wise to check with your compliance department about your company’s specific policies.
Unvested shares become a bit more tricky. Many companies and industries prohibit employee short-selling of their own shares, for obvious reasons. If your shares are not vested, selling them would be considered a short-sale and thus subject to any such restrictions. Similar restrictions may exist for purchasing put options (right to sell).
As an alternative, you may be able to sell short an ETF representing a large basket of stocks in your industry. An example would be selling XLF if you work for a company in the Financial Sector. Purchasing put options on such an ETF may also be an effective strategy to protect substantial downside and maintain growth potential. It is critical to know the correlation between the ETF you select and your own company stock. We also always advise consulting your compliance department before engaging in any such hedging strategies.
Sizing your hedge…
When considering how much of your unvested shares to hedge, think about the probability that those shares will vest. Remember, your departure from the company can have an impact on which (how many) shares will vest and when. Each stock grant has rules governing future vesting under various circumstances. You should read each stock grant’s prospectus before determining your expectation. That’s right….it can vary BY GRANT! If you hedge more of your stock than you eventually vest, you are effectively over-hedged. A conservative approach to estimating your future vesting is usually advisable.
When sizing your hedge, keep in mind the beta (relative sensitivity) and correlation of your company stock to your chosen hedging vehicle. The graph below shows the linear regression of the daily percent change of JP Morgan stock to XLF (financial sector ETF). With XLF as the independent variable, the beta is 1.109 (based on 2 years of data). This means that for $100k of JP Morgan stock that you wish to hedge, you would short $111k of XLF. For those of you math junkies (like us), keep in mind that switching the dependent and independent variables will produce different results. As a general rule, picking the more conservative ratio is reasonable, given most people don’t attempt to hedge all of their unvested shares anyway. It is also important to note that while an R^2 of 84 (as depicted by this graph) is good, it still can lead to material variation between JP Morgan and XLF (some of the dots are pretty far off of the line). Proper hedging is a great way to reduce your risk. HOWEVER, you MUST always carefully assess the risks of hedging to create the desired net risk profile.
Selling short vs. buying puts…
An alternative to selling short shares of a similar ETF to your company would be to purchase puts (put options), or the right to sell, on that ETF. This is very similar to purchasing insurance which pays you in the event that the ETF (and likely your company) stock drop materially. The term (time frame) and strike (price at which you can sell) will ultimately determine what you will pay for this insurance, and what its ultimate payout will be. Some employees simply want to protect against a catastrophic event, buying puts with a very low strike, which is relatively cheap insurance, since it only pays if the ETF drops significantly.
Lastly, if you own stock options, your approach when vested may be different. The true value in employer stock options comes with time. Simply exercising the options when vested and selling the stock is often NOT the best strategy. One might consider selling exchange traded call options against your vested employee options. This helps monetize some of the time value of your options and reduces some concentration risk.
With all of these strategies, keep in mind that an individual company stock price does not have perfect correlation to an ETF in the same industry. Historical correlations may vary materially in the future as well. This is one of the reasons why a conservative approach to sizing your hedge may be appropriate and why buying puts may be a safer strategy.
AS ALWAYS, you should ONLY transact in securities and instruments that YOU COMPLETELY UNDERSTAND. Consult your investment advisor for more details. You should always consult your compliance department before transacting in your own company’s securities. You should always consider the tax consequences of your transactions and consult your tax advisor.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
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