what s more it is all due in the same tax year and paid upon exercise with another likely tax hit at the sale or disposition of the acquired stock even if you have capital losses elsewhere in your portfolio you can only apply 3 000 per year of these losses against your compensation gains to offset the tax liability 8
after you have acquired stock that presumably has appreciated in value you are faced with the choice of liquidating the stock or holding it if you sell immediately upon exercise you have locked in your compensation gains the difference between the exercise price and stock market price but if you hold the stock and then sell it later after it appreciates you may have more taxes to pay remember that the stock price on the day you exercised your esos is now your basis price if you sell the stock less than a year after exercise you will have to pay the short term capital gains tax to get the lower long term capital gains rate you would have to hold the shares for more than a year you thus end up paying two taxes compensation and capital gains many eso holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise as the following example demonstrates let s say you have esos that give you the right to buy 1 000 shares at 50 and the stock is trading at 75 with five more years to expiration as you are worried about the market outlook or the company s prospects you exercise your esos to lock in the spread of 25 you now decide to sell one half of your holdings of 1 000 shares and keep the other half for potential future gains here s how the math stacks up to summarize note that this does not count the time value lost from early exercise which could be quite significant with five years left for expiration having sold your holdings you also no longer have the potential to gain from an upward move in the stock that said while it seldom makes sense to exercise listed options early the non tradable nature and other limitations of esos may make their early exercise necessary in the following situations basic hedging strategies for esosbasic eso hedging strategies include writing calls buying puts and constructing costless collars of these strategies writing calls is the only one where the erosion of time value in esos can be offset by getting time decay working in one s favor we strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager also review your company s code of ethics and or related policies there may be restricted practices on dealing in options related to your company in which you may be considered an insider say that the stock of xyz corp closed at 175 13 on november 15 the date on which the longest dated options available on the stock are the three year calls and puts let s assume you are an xyz employee who is granted esos to buy 500 shares of the company on nov 29 which will vest in 1 3 increments over the next three years and have 10 years to expiration for reference the three year 175 calls in the market are priced at 32 81 ignoring bid ask spreads for simplicity while the 175 puts trade at 24 05 here are three basic hedging strategies based on your assessment of the stock s outlook to keep things simple we assume that you wish to hedge the potential 500 share long position to just past three years of these strategies writing calls is the only one where you can offset the erosion of time value in your esos by getting time decay working in your favor buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk the costless collar has minimal cost but does not resolve the issue of eso time decay 