Questions and Answers on Managing Employee Stock Options

We look at repricing issues, taxes and using options to protect your position.
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Editor's note: The soaring stock market has left many participants in incentive stock-option programs sitting on substantial paper profits. Last month, David Edwards offered strategies for managing and diversifying out of these positions. Today, he follows up with questions and answers on several related issues.

Don't Count on Repricing

Won't employees be protected by options repricing if the company stock declines precipitously?

When a company's stock falls sharply, management may elect to reprice employee options to market levels. This move is extremely unpopular with outside shareholders, so you shouldn't count on its protection. Besides, management usually resets the vesting period, so you would have to wait longer to exercise your repriced options.

And what if the stock price doesn't recover? Here's a real-life example:

An employee of

Parametric

(PMTC)

had about $3 million in option appreciation when the stock was at 35. (He had options with strike prices ranging from 13 to 20.) After Parametric crashed to 10 in the spring of 1998, the company offered to reprice employees' options if they accepted a new three-year vesting period.

This employee accepted the repricing offer on options with strike prices greater than 18. The remaining vested options were kept at their original strike price. PMTC got as high as 17 recently before settling back to 13 7/8. The bottom line: His current position is a small fraction of $3 million.

LEAPS Are Limited

What if I sell a small fraction of my stock and buy LEAPS put options?

LEAPS (Long-term Equity Anticipation Securities) are like conventional stock

put and

call options except their expiration dates are one to two years in the future. LEAPS are illiquid for all but a handful of large-cap companies (such as

Dell

(DELL) - Get Report

,

Compaq

(CPQ)

and

Microsoft

(MSFT) - Get Report

) and may not be available for your company.

These options are expensive -- recently the Microsoft January 2001 160 put traded at 28 with the underlying stock at 156 1/2. To lock in a current position for two years would require an insurance premium equivalent to 18% of the current market value of the Microsoft position. Another caveat: Employee stock-option agreements often contain clauses prohibiting the purchase of puts or prohibiting short sales of the stock against restricted long positions of stock.

Caution on Covered Calls

What if I generate income by selling calls against my company stock or against my employee options?

At

Heron Capital Management, we're prejudiced against

covered call strategies in general because you cap your gains while leaving yourself exposed to substantial losses. (Gains from the sale of options will not cover more than a fraction of the loss you would sustain if the stock dives.)

Practically speaking, you would have to deposit your company shares in a brokerage account before you write calls against the stock. You can't deposit employee stock options in a brokerage account. Therefore, to write calls against options, you would be writing

naked calls as far as the brokerage house is concerned, and you would have to put up margin against the option sales. Keep in mind that all gains and losses from options trading are considered ordinary income and do not qualify for lower long-term capital-gains rates. Bottom line: This strategy still leaves you vulnerable to a sharp decline in your company's stock.

Don't Forget Withholding

Why aren't taxes on my gains due April 15 like those on any other income or gains?

You still have to file your tax return by April 15. What confuses people is that they sometimes must make estimated tax payments on big gains to avoid penalties for underwithholding.

The

IRS

requires that your current withholding cover 90% of this year's or 105% of last year's tax obligation. A big gain from the exercise of options and sale of stock could put you in jeopardy of underwithholding.

If your current level of withholding is higher than last year's tax bill, you don't have to worry about underwithholding penalties or interest, no matter how big your gain this year. (But you'll still owe taxes on your gain come April 15.) Otherwise, you need to be sure that taxes are paid on your gain in the quarter during which they were incurred.

We insist our clients' accountants be informed about what we're doing whenever we are assisting a client in diversifying out of a single company position. Generally speaking, we find that, as long as our clients have paid up on their gains by Jan. 15, penalties for underwithholding are kept to a minimum.

David Edwards is president of Heron Capital Management, a New York-based money management firm investing in U.S. equities and corporate bonds. His firm, which has $18.9 million under management, is consistently ranked among the top 20 in its category by the Nelson's "World's Best Money Managers" survey. At the time of publication, his firm held long positions in Microsoft, Dell, Compaq and Parametric, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

As originally published this story contained an error. Please see Corrections and Clarifications.