How to Protect Restricted Stock from Falling Prices or Poor Management
Restricted stock — given to or sold to an employee as an equity stake in a company — cannot be traded within a certain time frame. If the employee can't sell the investment, the restricted stock would seem to be unprotected from dramatic downturns in stock prices or from the company itself going out of business. However, there's a strategy that can protect your restricted company stock from the ravages of the stock market, or worse, management incompetence.
Called a collar, the strategy uses equity options on the company stock to protect it from any major downswings. An equity option is the right to buy or sell a certain stock, at a certain price, at a certain time.
Options come in two forms: calls and puts. Calls give you the ability to buy a stock and puts give you the ability to sell a stock. Options are derivatives, meaning their value is derived from the price of the underlying stock (in addition to a few other variables). When you purchase or sell an option, you purchase or sell nothing more than the promise to deliver or receive the stock at a certain price and time.
The benefit of an options collar is that it allows the restricted stock owner to protect their stock from large swings. The negative, however, is that it limits your upside growth. Generally, this is a fair tradeoff to an employee who is granted restricted stock as a part of compensation and who just wants to protect what he owns.
This strategy is achieved by purchasing a put option (the right to sell the stock) and selling a call option (the right to purchase the stock) to finance it. It's important to try to match the expiration of the options as close to the time frame when the restricted stock becomes accessible.
Here's an example: An employee of IBM has 1,000 shares of IBM stock that is restricted for three years. IBM is at $100 per share, and the employee doesn't want to lose too much of the $100,000 asset if the value of the stock should fall. This asset could be protected by selling enough calls to cover all of her shares with a strike price (the price at which the stock will be sold) of 105.
Selling those calls will provide her with some income. The amount varies based on many factors. However, once the income is received, she can use it to purchase put options. She would buy enough put options to cover the shares she owned at a strike price of 95. This means, once the restriction is lifted and she is able to sell her stock, if the price is below 95, she would then have the option to sell the stock at 95 using the put option.
The employee has collared the price of IBM between 95 and 105 for the next three years. If IBM stock falls to 50, she has only lost $5 per share. If it rises to 150, she has only made $5 per share. The point is, her restricted stock is protected. Be sure to discuss the details of this strategy with your financial advisor.