A concentrated stock portfolio may result from an outright purchase of the stock, receiving the stock as an inheritance, exercising employee stock options, or acquiring common stock or restricted stock as a form of compensation. Maintaining a portfolio that is over-concentrated in a single stock is speculative and exposes the investor to significant downside risk. This includes substantial business specific risk as well as substantial market risk. In some cases, an investor’s concentrated stock portfolio is used as collateral for a margin or bank loan. The effects of margin on a concentrated stock position substantially increases the risk to the investor’s account, and can lead to the forced liquidation of the underlying stock in order to satisfy a margin call if the stock declines precipitously in value. A forced sale of the stock can preclude the investor from recovering their losses in the stock through a potential rebound in the price of the stock. Failing to protect a concentrated stock position can have devastating effects and decimate the value of an investor’s net worth.

When an investor holds a concentrated stock position with a full-service brokerage firm, the firm is required to take steps necessary to protect the value of that stock. Unfortunately, despite having a duty to do so, many full-service brokerage firms fail to protect their customers’ concentrated stock portfolios by using risk management or hedging strategies. When an investor’s account contains a concentrated stock position, full-service brokerage firms have a duty to diversify away the risk in the investor’s account. Brokerage firms are required to either 1) recommend that the client sell and diversify; or 2) implement a risk management or hedging strategy to protect the concentrated stock position in the event of a decline in stock price. Brokerage firms also have an obligation to disclose to the customer the risks associated with holding a concentrated stock portfolio and ensure that the client understands those risks and is comfortable with assuming those risks.

According to the New York Stock Exchange’s Content Outline for the General Securities Registered Representative Examination, Test Series 7, the Critical Functions and Tasks of the Registered Representative include the following:

Monitors the customer’s portfolio and makes recommendations consistent with changes in economic and financial conditions as well as the customer’s needs and objectives:

7-1) Routinely reviews the customer’s account to ensure that investments continue to be suitable (emphasis added);

7-2) Suggests to the customer which securities to acquire, liquidate, hold or hedge (emphasis added);

7-3) Explains how news about an issuer’s financial outlook may affect performance of that issuer’s securities;

7-4) Determines which sources would best answer a customer’s questions concerning investments and uses information from appropriate sources to provide the customer with relevant information (emphasis added);

7-5) Keeps the customer informed about the customer’s investments (emphasis added).

Brokers employed by full-service brokerage firms are required to comply with the requirements set forth in the Series 7 Examination. These requirements include a duty to monitor their customers’ accounts and suggest that they either sell and diversify or hedge their concentrated stock positions.

In many cases, a holder of a concentrated stock position is completely in the dark and has no concept of the level of risk in their account or that their brokerage firm has strategies available to protect the value of their over-concentrated portfolio. A brokerage firm’s failure to disclose or recommend available risk management strategies for concentrated stock positions can equate to liability and create a cause of action against the firm for recoverable damages. This is particularly true when an investor places complete trust and confidence in their broker, and relies on the brokerage firm to make suitable recommendations.

Risk Management Strategies for Concentrated Stock Positions

Full-service brokerage firms have several risk management strategies available to protect accounts that are over-concentrated in a single stock. These strategies include:

1) “Zero-Cost” Collar

A “zero-cost,” or costless collar, is created by writing out-of-the money covered call options on the underlying stock, and purchasing protective puts at a cost equal to the premium received for selling the covered calls. Zero cost collars can be created to fully protect concentrated stock positions with little or no cost because the premium paid for the protective puts is offset by the premium received for writing the covered calls. Depending on the volatility of the underlying stock, the call strike can range from 30% to 70% out of money, enabling the writer of the call to still enjoy upside appreciation of the stock price in the event the stock price increases in value. This strategy is typically executed using LEAPS options as the strike price of the calls sold can be rather high in relation to the price of the underlying stock. LEAPS, or Long-term Equity Anticipation Securities, are long-term stock or index options that expire more than 9 months in advance, and can last as long as 2.5 years.

For example, suppose an investor inherits a large concentrated stock position in XYZ which is currently trading at $50.00 in June 2006, and he wishes to protect those shares in the event of a stock price decline. At the same time, he wants to hold on to the shares as he feels that they will appreciate in the next 6 to 12 months. In that scenario, the investor can enter into a zero-cost collar transaction by writing one year JUL ’07 60 call options while simultaneously using the proceeds received from the sale of the calls to buy one year JUL ’07 40 put options.

If the stock price rises to $70.00 at the expiration date of the call options, the investor’s maximum profit is capped as he is obliged to sell his shares at the strike price of $60.00 (unless he decides to buy back the calls). On the other hand, should the stock price plunge to $20 instead, his loss is limited to 20% of the value of the stock when the zero-cost collar transaction was effectuated, as the protective put options allow him to sell his shares at $40.00.

2) Protective Puts

Purchasing protective puts is a hedging strategy where the holder of a concentrated stock position buys put options to protect or guard against a decline in price of that stock. Essentially, buying protective put options is executing only one side of a zero-cost collar transaction. The protective put options will protect an investor’s concentrated stock position to the downside, while at the same time allowing for unlimited profit potential, as the upside will not be capped.

3) Stop Loss and Limit Orders

A stop loss order is an exit strategy to unwind a stock position when the price of the stock moves downward. The stop loss order is designed to limit losses or, in some instances, to lock in a certain level of profit. As soon as the price of the underlying stock hits the stop loss price (or falls below), the order becomes a market order. A holder of a concentrated stock position could enter a stop loss order at, for example, 20% below the current market price. If the stock were to suffer a precipitous decline, an investor’s losses would be limited to 20% of the price of the stock.

Limit orders can be established to take gains on a position by closing it out at a predetermined price. For a long position, a limit order is placed above the current price.

4) Variable Prepaid Forward Contracts

A prepaid variable forward contract is a risk management strategy that allows an investor with a concentrated stock position to generate liquidity for diversification or other purposes. Moreover, the investor will receive cash in hand without paying the capital gains taxes that would apply to a sale of the underlying stock.

A prepaid variable forward contract allows the investor to receive an up-front payment (usually, between 75% to 90% of the market value) in exchange for delivery of a variable amount of shares or cash in the future. Because the contract establishes floor and threshold prices that govern how many shares (or cash equivalent) are returned at a given market price, the investor will be protected against downside risk below the floor while enjoying appreciation potential up to the threshold.

5) Exchange Fund

Exchange funds are private placement limited partnerships or LLCs designed for an investor holding a concentrated stock position. When an investor enters into an exchange fund transaction, a brokerage firm establishes a fund where the holder of the concentrated stock position transfers some of their shares to the fund which are pooled together to create a diversified portfolio. Once the fund reaches its target size, it is closed and each investor in the fund receives an ownership interest in proportion to the value of their original contribution.

Unlike the majority of stock transactions, the transfer of stock to an exchange fund does not trigger any capital gains tax liability. Rather, these transfers are considered nontaxable partnership contributions under Section 721 of the Internal Revenue Code. Although Section 721 usually does not apply to contributions of stocks or other securities, an exception exists for funds meeting certain criteria.

Several financial institutions offer exchange funds which share similar structures, but can vary in investment objectives, composition and size. Some funds focus on building a portfolio of well-known large-cap stocks, while others lean more toward the mid-cap market. Other funds track major stock indices such as the S&P 500 or the Nasdaq 100.

6) Synthetic “Proxy” Hedge Transaction

An investor who holds a concentrated position in restricted or Rule 144 stock has certain restrictions on selling the stock, and in some cases restrictions on placing a “zero-cost” collar on the stock. In such instances, a brokerage firm can put a synthetic “proxy” hedge in place to protect the restricted stock. A synthetic hedge is a selection of marketable assets that together mirror the behavior of the restricted stock. By selling short the hedge components, this strategy could provide significant protection against downward movements in the price of the restricted stock.

One type of synthetic “proxy” hedge strategy known as a “put” basket can offset or hedge any declines in an investor’s restricted stock position. This scenario would require the short sale of a “basket” of highly correlated stocks through the use of margin on the day the restricted stock was held in the account. The efficacy of a proxy-based hedge strategy depends on the extent to which the securities’ price movement correlates with each other. This correlation in price movement has a statistical measure known as “R-squared”. The R-squared, also known as the “coefficient of correlation”, measures the “cross-basis” risk which determines the extent to which a proxy will be able to hedge the value of a concentrated restricted stock position.

A synthetic “proxy” hedge typically can be used for investors who hold:

Stocks that are difficult to hedge using traditional methods because either there are no exchange traded options available, or because the stock is hard to borrow rendering it a poor candidate for investment banks to write over-the-counter collars and prepaid forwards on.

Stocks owned by insiders, key employees, or board members that are restricted by Rule 144 or by internal company policy.

Stocks from industries where there are large pools of available hedge candidates with relatively low dividend yields (shorts must pay out this dividend).

Positions that are so large as to warrant diversifying hedging techniques between traditional hedges (puts, collars, etc.) and non-traditional hedges such as synthetic baskets.

7) Equity Swaps

Equity swaps are contracts through which an investor can exchange the returns to a concentrated position with the returns to a basket or index of securities. For example, an investor holding a concentrated position in XYZ stock worth $2,000,000 can agree to swap at periodic intervals the total return to $2,000,000 in XYZ for the total return to the Wilshire 5000, less a fee. The brokerage firm offering the swap can hedge the risk of the swap by trading in XYZ stock or options or by including XYZ in its own portfolio. At maturity, the investor owns $2,000,000 in XYZ at then current market prices plus the return to the benchmark index over the life of the swap.