Protecting Concentrated Stock Positions
Protecting Concentrated Stock Positions
Concentrated stock positions—typically from executive compensation, company founders, or inheritance—create significant single-stock risk. Hedging strategies can reduce risk without triggering immediate tax consequences, though each approach involves tradeoffs between protection, cost, tax treatment, and retained upside.
Definition and Key Concepts
Concentration Risk
A position is typically considered concentrated when:
- Single stock > 10% of net worth
- Single stock > 25% of liquid assets
- Position represents majority of wealth
Risks of concentration:
| Risk | Description |
|---|---|
| Company-specific | Earnings miss, scandal, competition |
| Sector risk | Industry-wide downturn |
| Market risk | General market decline |
| Liquidity risk | Difficulty selling large blocks |
Hedging vs. Selling
| Approach | Tax Impact | Upside Retained | Complexity |
|---|---|---|---|
| Outright sale | Immediate capital gain | None | Low |
| Protective put | No tax event | Unlimited | Moderate |
| Collar | No tax event (if structured properly) | Capped | Moderate |
| Prepaid forward | Taxed at sale (typically) | None | High |
| Exchange fund | Deferred until exit | Diversified portfolio | High |
Constructive Sale Rules
IRS constructive sale rules (Section 1259) may trigger gain recognition:
| Transaction | Constructive Sale? |
|---|---|
| Short against the box | Yes |
| Zero-cost collar (too tight) | Potentially |
| Put spread | Generally no |
| Wide collar | Generally no |
| Prepaid variable forward | Case-by-case |
Consult tax advisor before implementing hedges.
How It Works in Practice
Strategy 1: Protective Put
Structure: Buy put options on the concentrated stock.
Example:
- Position: 100,000 shares at $50 (value: $5,000,000)
- Protection: 90% of current value ($45 strike)
- Tenor: 1 year
- Put premium: $4 per share
Cost: 100,000 × $4 = $400,000 (8% of position)
Outcome:
| Stock Price | Position Value | Put Payoff | Net Value |
|---|---|---|---|
| $60 | $6,000,000 | $0 | $5,600,000 |
| $50 | $5,000,000 | $0 | $4,600,000 |
| $40 | $4,000,000 | $500,000 | $4,100,000 |
| $30 | $3,000,000 | $1,500,000 | $4,100,000 |
Floor established at $4,100,000 (82% of original value after premium).
Strategy 2: Collar
Structure:
- Buy out-of-the-money put
- Sell out-of-the-money call
- Net premium approximately zero
Example:
- Buy $45 put (90% strike): $4 per share
- Sell $60 call (120% strike): $4 per share
- Net cost: $0
Outcome:
| Stock Price | Position Value | Put | Call | Net Value |
|---|---|---|---|---|
| $70 | $7,000,000 | $0 | -$1,000,000 | $6,000,000 |
| $60 | $6,000,000 | $0 | $0 | $6,000,000 |
| $50 | $5,000,000 | $0 | $0 | $5,000,000 |
| $45 | $4,500,000 | $0 | $0 | $4,500,000 |
| $30 | $3,000,000 | $1,500,000 | $0 | $4,500,000 |
Range: $4,500,000 to $6,000,000 (90% to 120% of original).
Strategy 3: Prepaid Variable Forward
Structure:
- Receive upfront cash (discounted value)
- Deliver shares at maturity (variable quantity based on price)
- Similar economics to selling but with potential tax benefits
Terms example:
- Upfront: 80% of current value ($4,000,000)
- Floor: $45
- Cap: $60
- Term: 3 years
Settlement at maturity:
| Stock Price | Shares Delivered |
|---|---|
| Below $45 | 100,000 |
| $45-$60 | Variable (100,000 to 75,000) |
| Above $60 | 75,000 |
Worked Example
Situation:
- Executive holds 50,000 shares of employer stock
- Current price: $100 per share
- Position value: $5,000,000
- Cost basis: $10 per share (low basis)
- Need: Protect 80% of value without triggering tax
Analysis:
| Strategy | Cost | Protection Level | Upside Cap | Tax Risk |
|---|---|---|---|---|
| Protective put (90%) | $250K (5%) | $4,500,000 | Unlimited | Low |
| Collar (85%-125%) | $0 | $4,250,000 | $6,250,000 | Low |
| Collar (90%-110%) | $0 | $4,500,000 | $5,500,000 | Moderate |
| Prepaid forward | Receive $4M | $4,000,000 | $5,500,000 | Moderate |
Recommendation: Wide collar (85%-125%) provides free protection while avoiding constructive sale rules.
Hedge Ratio
For collar on 50,000 shares:
- Buy 500 put contracts (85 strike, 100 multiplier)
- Sell 500 call contracts (125 strike, 100 multiplier)
VaR comparison:
| Scenario | Unhedged VaR | Collared VaR |
|---|---|---|
| 95%, 1-year | $1,500,000 | $750,000 |
| 99%, 1-year | $2,500,000 | $750,000 |
VaR reduction: 50-70%
Risks, Limitations, and Tradeoffs
Cost Considerations
| Cost Element | Protective Put | Collar |
|---|---|---|
| Premium | High (3-8% annually) | Low to zero |
| Opportunity cost | Upside unlimited | Upside capped |
| Transaction costs | Moderate | Moderate |
| Margin | None (long options) | May require |
Tax Complexity
| Issue | Description |
|---|---|
| Constructive sale | Too-tight collar may trigger gain |
| AMT | Option premium may create AMT exposure |
| Timing | Short-term vs. long-term treatment |
| Estate planning | Hedged positions have specific rules |
Liquidity Requirements
| Strategy | Liquidity Needed |
|---|---|
| Protective put | Premium upfront |
| Collar | Margin for short call |
| Prepaid forward | None (receive cash) |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Constructive sale | Collar too tight triggers tax | Use wide strikes |
| Illiquid options | Single stock options may have wide spreads | Check liquidity before committing |
| Short call assignment | Early exercise on short call | Monitor dividend dates |
| Basis miscalculation | Wrong tax impact estimate | Work with tax advisor |
Alternative Strategies
Exchange Funds
Structure: Contribute concentrated stock to partnership; receive diversified exposure.
Benefits:
- Tax-deferred diversification
- Professional management
Requirements:
- Typically $1M+ minimum
- 7-year lock-up common
- Must be accredited investor
Charitable Strategies
| Strategy | Benefit |
|---|---|
| Charitable remainder trust | Income stream + deduction |
| Donor-advised fund | Immediate deduction, avoid gain |
| Private foundation | Control over giving |
10b5-1 Plans
Systematic selling under predetermined plan:
- Pre-established timing and amounts
- Provides defense against insider trading allegations
- Gradual diversification over time
Checklist and Next Steps
Pre-hedge assessment:
- Calculate position as % of net worth
- Determine cost basis and tax implications
- Define protection level needed
- Assess upside participation requirements
- Check for contractual restrictions (lock-up, blackout)
- Consult tax advisor on constructive sale rules
Strategy selection:
- Evaluate protective put cost
- Model collar scenarios
- Assess prepaid forward terms
- Consider exchange fund eligibility
- Document strategy rationale
Implementation:
- Obtain option quotes
- Verify strike selection avoids constructive sale
- Execute hedge trades
- Establish monitoring procedures
- Plan for roll or expiry
Related articles:
- For portfolio-level hedging, see Using Options to Hedge Equity Portfolios
- For commodity hedging, see Using Futures to Hedge Commodity Exposure