A growing area of our practice is in using stock options to help clients manage their investments. Options have a number of use cases that come in handy, such as:
- Generating income off of concentrated stock positions
- Hedging against a decline in the future value of an equity award
- Using options to get back into a stock or the market
We’ll touch on each of these scenarios below using examples. If your own investments come to mind while reading, options may be a tool you should add to your investment strategy.
Concentrated stock
A concentrated stock position can be defined as an investment that makes up more than 20% of one’s total investment portfolio. For example, a $1 million stock portfolio with $200 thousand in a single stock is a concentrated position. These positions represent significant upside and downside risks. In some cases, the $200 thousand position grew to that size organically. For instance, $20,000 invested in Tesla (TSLA) five years ago would be worth more than $260,000 today.
An investor may not want to sell that position due to tax reasons or personal circumstances. However, options can be used to provide that investor with flexibility around that position. One popular strategy is to sell “covered calls” against the Tesla position. Doing so may generate upwards of 10%-20% in interest income throughout the course of the year. Additionally, covered calls can lock in a future sale price today. Perhaps the investor doesn’t want to sell Tesla at the current price of $250 per share, but they would like to sell Tesla if it is above $300 in six months. An option strategy can be used to lock in that future sale price while offering some protection against potential downside.
Hedging future stock awards
A number of our clients have a large chunk of their compensation or net worth tied up in company stock by way of future equity awards. While companies often restrict the hedging strategies an employee can use, we have a number of ways around such restrictions. One way is to use proxies, or securities in the market that trade similar to the stock we want to hedge against. For example, if our client works in tech and has large exposure at their tech employer, we can use a technology ETF to hedge the present value of their future shares.
Consider a scenario where an employee of a technology company is going to receive $3 million worth of stock over the next three years, paid out in $1 million tranches per year. The stock is worth $3 million today but there’s no certainty over what it will be worth as it vests. We could employ an option strategy called a collar on a tech heavy ETF like QQQ. While this wouldn’t give us a perfect 1:1 hedge against the employee stock, it would give the employee some protection. If the tech heavy QQQ fell, it would increase the odds that tech stocks like the company the employee works for is falling as well.
When using option strategies to hedge employee stock positions, its crucial to read your employer’s equity plan documents. Those documents will contain important information on what your options are when it comes to using hedging strategies. In most cases, you cannot hedge your company stock directly, but you can use indirect proxies.
Using options to get back into stocks
Another popular way we use options is to help clients get back into a certain stock or index. Take our Tesla example above, but let’s say that the investor did sell the stock at $250 today instead of waiting. They could then use options to try and buy the stock back.
Here’s how it would work based on selling 100 shares of Tesla for $250 per share. In that case, the client has $25,000 in cash from the sale.
They could then use those proceeds to sell a $240 strike put in Tesla for January 2025 for $30. Doing so would give them a cash credit of $3,000 (options are multipliers of 100). This translates to a cost basis in Tesla of $210 ($240 strike minus the $30 they sold it for).
If Tesla stock is above $240 in January 2025, they get to keep the $3,000 they earned from selling the option. If you tack that $3,000 on to the $25,000 they received when they sold the stock, their total proceeds were $28,000. This would be the same as if they had sold Tesla stock at $280 per share instead of $250.
If Tesla stock is under $240 in January 2025, they’d get the stock back for $210 per share, 16% below their $250 sale price. The downside of this strategy would be if Tesla went much lower than $210 or much higher than $280. In those cases they’d either have losses or missed out on additional profits.
Who should use options?
Options are not for everyone. They are complicated instruments that come with significant risks. But they also provide flexibility and have impactful use cases in the market. Options are especially useful for investors who have large single stock positions or major equity exposure. In addition, they can be useful for hedging against the future value of an equity award for employees of publicly traded companies. Options can also provide ways back into a specific stock or the market in general. We think of options as a tool in a high net worth investor’s toolkit, not as a replacement for traditional investing.
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