hedge employee stock options using collar?
Hello Mark

A colleague has been given 500,000 Microsoft shares which can only be exercised one year later. He does not need to dip into the proceeds even after one year. What should he do so that things work out to his advantage?


Hi Agnes,

I wish I had such problems.

'Need" to dip into the proceeds is not the same as he 'doesn't want to' dip.  Whether he is considering lightening his holdings by selling shares as time passes, or prefers to keep all the shares, the collar works well and he would simply re-establish that collar every year when the current collar expires each January.

There is an alternative strategy - that I don't like to use myself, but it represents an excellent method for being certain a big dip in the price of his stock doesn't crush the value of his investment.  He'll still have a chance to make some money, if the stock rises by a significant amount.  And that's to buy the put without selling the call.

MSFT is currently trading slightly over $30 per share.  He can buy the MSFT Jan09 30 put for close to $3.  That's about 10% of the value of his holdings and it seems like a lot to pay.  But, it does guarantee that his shares will be worth at least $27 each come next January 16.  The upside to buying these puts (and he needs 5,000 of them) is that his potential upside is unlimited.

If he wants to be more prudent and not worry about making another killing to the upside, he can recover a significant portion of the cost of the puts by selling 5,000 calls to create a collar.  The MSFT Jan09 35 call can be sold for $1.65 to $1.70.  That recovers more than half of the cost of the puts.  If he is more bullish, he can sell a higher strike call.  And if he is more bearish and his main priority is protection, he can sell the 32.5, or even the 30 call instead.

Yes, the collar is the best choice, unless he is very bullish.

Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options