A single position that represents more than 10% of your liquid net worth can be too concentrated. (This is for most investors, your financial plan may be able to withstand concentration risk, see the Concept of Excess.) Lots of companies offer stock options, stock awards, or match 401k contributions with stock. Employees will build these positions over time and may not realize how much of their worth is tied to a single company. 

There are benefits to holding company stock other than the price going up. A sense of pride comes with owning a piece of a company that you work so hard for. Net unrealized appreciation is another benefit where company stock distributions can be taxed at long-term capital gains rates versus ordinary income. Sometimes it pays off if your company can withstand the test of time.

Some pitfalls are overconcentration risk. I’ve wrote about my conversation about the former GE engineer who had a big portion of his worth tied to GE. It is common for employees to have too much company stock because they either didn’t realize how much they own or have too much confidence in their own company. See Enron. 

Enron employees thought they worked for the greatest company on earth, and they did on paper. Only the ink on the paper were all lies. Those Enron workers put everything they had in company stock because it was beating the stock market by a wide margin. No one knew how badly the books were manipulated, if at all, and investors kept piling in. 

This is not to say that your employer’s stock will drop considerably in value, but rather to paint the potential downside from concentration risk. Here are some considerations for any owner of concentrated stocks. 

Sell and diversify

This is the preferred strategy because it is the most direct way to bring any single exposure below the 10% threshold. Yes, we’ll potentially miss the booms but more importantly, we are reducing the impact of the busts. Sometimes there are taxes to consider and many holders of stock hold on for this reason alone. 

Build around the position

It takes some knowledge to understand what kind of stock your company is. If it is a small cap tech company, investors can balance out the volatility with a blue chip large-cap stock, possibly tilted towards value. Diversification is key here as well. If the company stock crashes, we’d expect the other holdings to move in other directions (hopefully up) to buffer against losses. Investors use other assets to build a moat around a position that can potentially go to zero. 

Create a “Dividend” Through Writing Covered Calls

Caution - I’m introducing options and relatively advanced concepts below. Please reach out to an investment professional to further your understanding, and to determine if these strategies are appropriate for your situation. 

Owners of concentrated stock have quite a bit of flexibility, even if taxes are keeping them from selling.  While options allow for investors to increase or reduce their risk exposures, we’re going to focus on risk reduction.

Creating a “dividend” does require stockholders to sell options on their stock. Selling a call option gives someone else the right to buy that stock at a predetermined price. The “dividend” in this case is the premium you would receive when a call option is sold. 

For example - The seller of a call option would agree to sell their stock at $120 at a future date. The stock is currently worth $100. By selling the option, the investor is giving up potential upside exceeding $120 per share. If at expiration, the stock is trading at $130, the investor loses $10 in upside. The stock gets called away and the investor receives $120 per share, even though the stock is worth $130. If the stock trades anywhere below $120 at expiration, the option expires worthless. The benefit to the seller is she gets to keep her stock and the premium she earned when she sold the option. 

There are several potential benefits to this strategy. First, if the price doesn’t reach the contract price on expiration, the premium is still earned. Second, if the shares are called away, it’s as if we sold our concentrated shares which helps us diversify. The biggest risk selling covered calls is a big run up in the stock value. 

Protect the Downside by Buying Puts

Put contracts are a form of stock option. There might be familiarity with call options (an option to buy a stock at an agreed-upon price). Puts work in the opposite direction where an option holder has the right to sell a stock at an agreed-upon price. This benefit goes to the holder if the price of the stock drops.

For example - A stock trading at $100 has a put contract on it for $90. If the price of the stock drops to $80, the put contract is worth $10 (the difference between the $90 strike minus the current value of the stock). Now the owner of the put has the right to sell the stock at $90, even though it is trading at $80.

Put contracts cost money and have an expiration date. If the price of the stock doesn’t drop before expiration, the put expires worthless. 

Options Collars - Buying Puts & Writing Covered Calls

Investors can fund the puts by selling call options against the stock held. 

For example - An investor owns a stock trading at $100 and sells call options for $120. By selling call options there is a premium earned. Using that premium, she then buys put options for $90 which “collars” the stock. She limits her upside but also limits her downside.  

When options are brought up, people tend to think higher risk. The options used in the above example are a risk hedging strategy, or risk reduction strategy. Our investor is using options to protect her concentrated position and defining her potential outcomes, especially to the downside. 

This is relatively advanced so please consult with a professional if this sounds like a viable strategy. 

Option contracts trade through a clearing house so buyers and sellers of options do not run into counterparty risk, meaning investors don’t have to worry about who’s on the other side of the trade. 

DISCLOSURES: 

No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
All investments include a risk of loss that clients should be prepared to bear. The principal risks of CWA strategies are disclosed in the publicly available Form ADV Part 2A.

Options investing entail a high degree of risk and may not be appropriate for all investors.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The information contained above is for illustrative purposes only.