3 Key Stock Options Strategies to Hedge Concentration Risk
Equity compensation is a significant component of employee comp packages in the tech industry. However, tech stocks can be volatile and subject to fluctuations that can impact employees' income and wealth accumulation. In this article, we will explore effective hedging strategies to help employees mitigate risk while maximizing their equity compensation.
Equity options hedging strategies are a popular tool for investors who want to protect their concentrated stock positions or increase their yield while minimizing their risk exposure. Three commonly used options strategies for hedging stock positions include writing covered calls, buying put contracts, and options collars. In this blog, we will explore each strategy in-depth and provide examples to help you better understand how they work.
Investing in options involves significant risks and is not suitable for all investors. Options trading may result in the loss of some or all of your invested capital. It is important to fully understand the risks and potential rewards before engaging in any options trading activities. Always consult with a financial advisor before making any investment decisions.
1. Writing Covered Calls
One popular hedging strategy is writing covered calls, which involves selling call options on a stock that an investor already owns. This generates income from the stock position as the investor receives a premium payment for selling the call option. If the stock price rises above the strike price, the buyer of the call option may exercise their right to purchase the stock at the strike price, and the investor will be obligated to sell it at the agreed-upon price, regardless of the market price.
For example, an investor purchases 1,000 shares of XYZ Corp stock trading at $10 per share, and they can sell ten call options (1,000 shares owned / 100 shares per contract = 10 contracts) with a strike price of $15 and an expiration date three months from now. The investor would receive a premium of $100 per option, for a total of $1000. If the stock price remains below $15, the call options will expire worthless, and the investor will keep the $1000 premium. However, if the stock price rises above $15, the buyer of the call option may exercise their right to buy the stock at the strike price of $15, and the investor will be obligated to sell it. In this case, the investor would make a profit of $5 per share (the $15 strike price minus the $10 purchase price), plus the $1000 premium they received for selling the call option.
Pros:
Generates additional income from the stock position.
Limits downside risk since the investor owns the underlying stock.
Can increase yield on a stagnant stock.
Cons:
May limit potential gains if the stock price rises above the strike price.
The investor is obligated to sell their stock if the call option is exercised.
2. Buying Put Contracts
Another common hedging strategy is buying put contracts, which give the investor the right, but not the obligation, to sell their stock at a predetermined price, known as the strike price, before the option's expiration date. Put options protect an investor’s stock position against potential losses if the stock price declines.
For example, if an investor owns 1,000 shares of ABC Inc stock trading at $10 per share and is concerned that the stock price may decline, they can purchase ten put options with a strike price of $8 and an expiration date three months from now. They might pay a premium of $20 per option, for a total of $200. If the stock price falls below $8, the put options will increase in value, allowing the investor to sell their shares at the strike price of $8, limiting their losses. However, if the stock price remains above $8 at expiration, the put options will expire worthless, and the investor will lose the $200 premium paid for the options.
Pros:
Protects against potential losses if the stock price declines.
Provides a way to sell shares at a predetermined price.
Cons:
The investor must pay a premium for the put option.
3. Options Collars
An options collar is a hedging strategy that combines both covered calls and put options. It involves buying a put option to protect against potential losses and selling a call option to generate additional income.
The put option protects against potential losses by giving the investor the right, but not the obligation, to sell their shares at a predetermined price, while the call option generates additional income by giving the other buyer the right, but not the obligation, to buy their shares at a predetermined price.
Let's take an example to illustrate how an options collar works. Suppose you own 1,000 shares of DEF stock, which is currently trading at $80 per share. You want to protect your stock position against potential losses while generating additional income, so you decide to implement an options collar.
First, you purchase ten put options with a strike price of $75 and an expiration date three months from now. You pay a premium of $3 per option, for a total of $300. This put option provides you with the right to sell your shares at $75 if the stock price falls below that level.
Next, you sell ten call options with a strike price of $85 and an expiration date three months from now. You receive a premium of $4 per option, for a total of $400. This call option gives the buyer the right to purchase your shares at $85, but you still own the shares and receive the premium.
By combining the put and call options, you have created an options collar that protects your stock position against losses below $75 and generates additional income if the stock price remains below $85. If the stock price rises above $85, the buyer of the call option may exercise their right to purchase your shares at the strike price of $85. However, if the stock falls you still have the right to sell your shares at $75, limiting your potential losses.
Pros:
Protects against potential losses while generating additional income
Limited downside risk, as you own the underlying stock
Cons:
May limit your potential gains if the stock price rises above the call option strike price
More complex than other hedging strategies
Tax Implications
It is essential to consider the tax implications of any hedging strategy involving equity compensation. Depending on the specific strategy employed and the investor’s tax situation, there may be tax consequences to consider.
Writing Covered Calls: The premium received from selling the call option is taxable income, and it must be reported on the investor’s tax return in the year it is received. If the call option is exercised, the investor will realize a capital gain or loss on the sale of the underlying stock, which may result in additional tax consequences.
Buying Put Contracts: The premium paid for the put option is a deductible expense, as it may offset any gains realized from the sale of the underlying stock. If the put option is exercised, the investor will realize a capital gain or loss on the sale of the underlying stock, which may result in additional tax consequences.
Options Collars: The tax implications of an options collar depend on the specifics of the strategy employed. If the investor sells a call option and buys a put option simultaneously, there may be little or no tax consequences if the options expire unexercised. However, if the options are exercised, the investor will realize capital gains or losses on the sale of the underlying stock, which may result in additional tax consequences.
It is always recommended to consult with a tax professional or financial advisor before engaging in any hedging strategy involving equity compensation to fully understand the tax implications and potential consequences.
Industry Volatility
The tech industry is known for its volatility, and employees who receive significant equity compensation may be particularly sensitive to this. When considering hedging strategies, it's important to take into account the impact of industry volatility on your investments.
In a volatile market, hedging strategies may not be as effective as in a stable market. For example, put option premiums increase dramatically during periods of high volatility, which may make this hedging strategy less cost effective. Additionally, changes in industry trends or news may have a significant impact on the stock price of individual companies, and indirectly impact the valuation and/or exercise of these options contracts. It's important to stay up-to-date on industry news and trends when implementing hedging strategies.
In Closing
Hedging strategies using equity options can be an effective way to protect your concentrated stock position or increase your yield while minimizing your risk exposure. Each strategy has its own pros and cons, and it's essential to understand them before deciding which strategy to use.
Writing covered calls can generate additional income while providing limited downside risk, but it may limit your potential gains if the stock price rises above the strike price. Buying put contracts can protect against potential losses but can be expensive, as you must pay a premium for the put option. Options collars combine both covered calls and put options to provide protection against potential losses while still allowing for potential gains.
As with any investment strategy, it's important to consult with a financial advisor and conduct thorough research before making any decisions. With careful consideration and planning, equity options hedging strategies can be a valuable tool in your investment arsenal.
DISCLOSURES:
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Options investing entail a high degree of risk and may not be appropriate for all investors. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
All investments include a risk of loss that clients should be prepared to bear. The principal risks of CWA strategies are disclosed in the publicly available Form ADV Part 2A.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.
