Would’ve, Should’ve, Could’ve…
Hedging for Non-Billionaires

Of course, hindsight is 20/20, but how many times in the last two years have Sprint employees wished they had sold their company stock and/or options before FON and PCS came crashing down? How about Cerner employees? And what about current Accenture partners (formerly Andersen Consulting)? Not to mention the employees at Enron!

Mark Cuban, founder of Broadcast.com, sold his company to Yahoo! in 1999. He has to be one of the smartest men alive. According to the August 2001 issue of the Robb Report, Cuban and his partner sold out to Yahoo! for more than $5 billion in Yahoo! stock. But, even after Yahoo! stock crashed like a lead zeppelin, he still had that “B” for billionaire after his name.

How did he do it without selling his stock? Cuban took advantage of a structured hedging strategy called an Equity Collar. Sounds exotic doesn’t it? It’s really not. As a matter of fact, there are several other strategies that “non-billionaires” can take advantage of that could mean the difference between early retirement and working many more years…not to mention sleeping well at night.

Protective Puts, Equity Collars, and another special vehicle called an Exchange Fund are three types of structured hedging strategies that could potentially save you thousands, if not millions of dollars if properly implemented as part of your strategy for controlling your investment risk in one stock.

Protective Puts are fairly simple and limit the downside risk of an investor’s concentrated stock holding while not putting any restrictions on the future upside. They involve purchasing a put option (which gives the right to sell at a specific price), but require an upfront cash payment for that protection.

Equity Collars are slightly more complicated and work by simultaneously limiting the investor’s downside risk and capping their potential upside gain for little or no cost to the investor. Cashless collars are the most popular since there are no out-of-pocket costs involved in this hedge.

Here’s how they work. An investor holds a position of 100,000 shares in XYZ stock with a current market price of $100, so total value is $10 million. In order to protect the overall value of the position, defer taxes for a year, minimize upfront costs, yet allow some participation in the future upside of the stock, the investor could implement a cashless collar hedge.

By purchasing a put option that limits the downside in the stock to 90 percent of the current value and simultaneously selling a call option that limits the upside to 120 percent, the investor can use the proceeds from selling the call to pay for the put. In this example, the put option gives the investor the right to sell the stock for $9 million, limiting his maximum loss to $1 million. By selling the call option, the investor is giving someone else the right to purchase his 100,000 shares for $12 million, which limits his upside potential. Once stocks are collared, they become assets against which financial institutions are willing to lend or advance cash. Cashless collars are excellent tools when implemented properly.

One other structured solution is a special vehicle called an Exchange Fund. An Exchange Fund allows investors to achieve diversification out of their concentrated equity position, defer taxes, and invest in a diversified portfolio of stocks concurrently. These special funds are available only to qualified purchasers who have at least $5 million in investable assets.

While these strategies require more explanation than is allowed here, they are available for qualified individuals and can really be a blessing for an investor. Hedging your stock can be a coolheaded and rational maneuver. Sadly, those qualities have been in short supply over the last two years. So, don’t let hindsight be your only 20/20 vision. Explore all your avenues, and make the most informed decision you can. Your future, your net worth and your peace of mind are depending on it!!

John R. Hanahan MBA is president of Yukon Capital Management Inc. Contact him at 913.681.9200 or by e-mail at JHanahan@YukonCM.com.