Download Chapter 41 Tools & Techniques of Investment Planning

Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are they?
• The Chicago Board Options Exchange defines hedging
as “a conservative strategy used to limit investment loss
by effecting a transaction that offsets an existing
position”
• Hedging is a form of investment insurance.
– It transfers risk from one person or entity to another.
– Hedgers may have to pay a “premium” or be otherwise willing
to forgo potential investment returns to shift risk.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are they?
• The difference in perception between a risky strategy
and a hedge depends on each investor’s:
–
–
–
–
–
Circumstances
Other investment holdings
View
Forecast of future events
Perception of market conditions
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are they?
• Investors may employ hedging strategies and tools to
reduce risk, or even “immunize” their investment
holdings in stocks, bonds and other debt instruments,
commodities, futures, and other investments against
almost any conceivable risk.
– Their scope ranges from those employed at the portfolio level
to the asset-class, sector, or industry level, to the individual
security or investment instrument level.
– The time frame for employing them may range from same-day
to overnight to years.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are they?
• Hedging involves:
– “Tools”: Certain investment instruments
– “Techniques”: Strategies
• In the “techniques” area, first and foremost are the
fundamental principles of sound investing:
diversification and asset allocation.
– Investors can usually eliminate nearly all of the companyspecific risk of stocks, the security-specific risk of individual
investment instruments, selection risk, and country-specific risk
by diversifying and investing in a large number of securities
within a given asset class, sector, or industry, and across a
number of countries.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are they?
• In the “techniques” area, first and foremost are the
fundamental principles of sound investing:
diversification and asset allocation (cont’d).
– Investors can further reduce their exposure to loss within a
given asset class, sector, or industry by allocating portions of
their portfolio among different assets or asset classes whose
returns are not highly correlated (or even inversely correlated)
with each other.
• Many of the “tools” involved in hedging are “derivative”
securities, such as options contracts, forward and
futures contracts, and other derivatives.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
When is the use of such devices indicated?
• Investors want to protect current security values from
price decline when they must make quick decisions with
limited information.
• An investor is uncomfortable with a large percentage of
value in a single stock (a concentrated portfolio) but
does not wish to sell and trigger capital gains taxes at
the present time.
• An investor has a large holding that is facing an almost
certain dramatic movement up or down, but the
question is which?
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
When is the use of such devices indicated?
• An investor may own a large position in a stock that has
trading restrictions due to:
– Initial Public Offering (IPO) lock-up provisions
– Trading restrictions imposed by the government or the company due to
insider status or other factors
• An individual with a short life expectancy due to
advanced age or illness (or as spousal beneficiary of a
marital trust) may wish to protect against a decrease in
stock or equity portfolio value (to protect the value of the
assets for heirs), but may not wish to sell because the
appreciated positions would receive a step-up in basis at
death.
– Substantial capital gains taxes would be incurred if sold before death.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
When is the use of such devices indicated?
• An individual may be in need of liquidity for various
cash flow needs but does not wish to trigger capital
gains taxes.
• Investment advisers, trust officers, investment
managers, or other fiduciaries responsible for other
people’s money want to meet their fiduciary duty to
protect the value of the total portfolio.
– This can be facilitated by diversifying and hedging against
declines in value of their clients’ investments.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
How is it done?
• Fundamental Investment Principles:
– Employing the sound investment fundamentals of
diversification and asset allocation is the best way for investors
to reduce the risk of their investments.
• The single biggest contributor to an individual stock’s price
volatility is its individual business risk (60% to 80%)
• This risk is unsystematic risk that investors can eliminate by
diversifying into many companies rather than just one or a few.
• By diversifying into a number of companies, investors will earn the
average return for the group, but with considerably less average
return volatility than that associated with any single company
within the group.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
How is it done?
– Investors can also manage the level of their exposure to
systematic risk factors by diversifying across sector, industry,
or asset classes.
• The process of asset allocation and portfolio management.
• Different sectors, industries, and asset classes tend to respond
differently to:
– Changing economic conditions
– Periods in the business cycle
– Various economic, social, political, and other major events
– When investors can fully employ these principles, the need to
hedge investments in any particular security, group of
securities, industry, or asset class becomes negligible and the
cost engage in such hedges is generally prohibitive.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
How is it done?
• At any given time, for whatever reasons, investors
might have a “concentrated portfolio” that they cannot
or choose not to “fix” using the fundamental principles
of investment and portfolio management.
– A “concentrated portfolio” is a portfolio that is over-invested in
a particular security or asset class and, therefore,
overexposed to risks associated with that investment.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
How is it done?
• In volatile markets, investors’ portfolios may quickly
deviate from their preferred mix among asset classes
and expose them to market and asset-class risk levels
that they deem unacceptable.
– Making adjustments all at once to move back to their preferred
asset mix and risk/return profile may be difficult and expensive
as well as disadvantageous for tax purposes.
• Such investors should consider hedging strategies.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• In many cases, simply closing out or selling a position
is the best decision when an investor finds it necessary
to diversify a security or asset class.
• Often investors can also sell loss assets in their
portfolio to offset gains and neutralize tax effects.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Investors overexposed in a security or asset class
cannot always be sure that:
– They will recognize the need to rebalance, or
– They will have sufficient time to “manage” the sale of the
position and offsetting loss positions before the appreciated
position declines in value.
• Two relatively simply techniques that investors have to
protect themselves from loss in these situations are:
– Stop-loss orders
– Short sales
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Stop Loss Orders:
– They are generally good-till-cancelled or standing orders with
brokers to sell (or buy) a security held long (short) if the price
moves below (above) a specified value
– The problems with stop-loss orders are three-fold:
• The investor has to or should reassess and reset the stop-loss
orders as the value of the position changes.
• The broker will actually sell the position if the market price hits the
stop-loss price
– The investor will be liable for tax on any gains realized
• Investors have no assurance that trades triggered by their stoploss orders will take place at a price that is anywhere close to their
stop-loss trigger price
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Short Sales:
– This strategy involves selling securities borrowed from a third party.
• In general, the investor’s broker or custodian arranges to borrow the
securities from the margin account of one of its other customers.
– While short-sellers maintain their short position, they must reimburse
the lenders for any dividends or interest paid on the borrowed
securities
– If the securities decline in value, the short-seller may then purchase the
securities on the open market at a lower price than the initial sales
price
• The short-seller then returns the purchased stock to the third party and
pays tax on the gain at long-term or short-term capital gain tax rates,
depending on the holding period.
– If the short-seller closes out the short position by buying the securities
after they have appreciated in value, the loss is treated as long-term or
short-term capital loss.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Short Sales Against the Box:
– Investors sell short securities that they also hold long in their portfolio.
• This technique offers perfect inverse correlation because gains or losses on
the long-position are perfectly matched by losses or gains on the short
position.
• As long as an investor maintains both the long and short position, the
economic value of the investor’s position cannot change.
– This strategy was originally used primarily for tax timing purposes.
• Now treated for income tax purposes as constructive sales, making them
much less attractive for hedging purposes.
– Although investors can still use this technique to prevent economic loss
on an appreciated position indefinitely, they generally will have to realize
their gain and pay tax on the appreciated long position in the tax year in
which they enter into the short sale against the box.
• Long position receives stepped-up basis
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Short Sales of Close Substitutes:
– The investor selects a short sale involving securities of a
company in the same industry, which has a close, but not perfect,
correlation to the securities the investor wants to protect.
• In general, even if closely correlated, short sales of a different
company’s securities will not be treated as a constructive sale.
• Circumvents the currently unfavorable constructive sale rules for
short selling against the box.
• Any time correlation is not perfect, a hedging strategy can fail.
– Individual business risk is generally greater than the industry or market
risk.
– Investors cannot use short-selling strategies to hedge perfectly against
company-specific events such as fraud or massive liability, unless they
short that specific company’s securities.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Short Sale of Exchange-Traded Funds (ETFs):
– ETFs permit investors to buy long or sell short certain baskets
of stocks.
• Such as the basket of stocks that comprise an index like the S&P
500 or NASDAQ 100.
– This can provide investors with a more broadly diversified
correlation (or inverse correlation) for market and industry or
asset class risks.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Selling a Forward Contract of Futures Contract:
– A forward contract is a contract negotiated privately or traded
over-the-counter to deliver a security at a specific time in the
future, at a specific price.
• With the advent of single-stock listed futures contracts on an everincreasing number of companies, investors can now sell
standardized futures contracts on many companies.
• Futures and forward contracts will trigger the constructive sales
rules.
– They are substantially identical property.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Offsetting Notional Principal Contract or Equity Swap:
– An offsetting notional principal contract is one where the holder
of a security or bundle of securities agrees to pay substantially
all of the investment yield and appreciation from the security or
the bundle of securities for a specified period.
• Generally, in return, the investor receives interest based upon an
interest rate index or a bond index.
• The investor generally is also reimbursed for substantially any loss
of value in the security or bundle of securities.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• Pre-paid Forward Sale:
– A pre-paid forward sale is a risk management strategy suitable for
investors whose primary goal is to monetize a concentrated equity
position without incurring an immediate tax liability.
• May be appropriate for investors who have legal restrictions or practical
limitations on selling their stock.
– Investors may received an up front payment of 75% to 95% of the
value of their stock rather than the traditional payment for the full
contract amount at the time the contract matures.
• Generally, the investor making the forward sale has no obligations to the
counterparty until the expiration of the transaction.
• The amount of the up-front payment may be affected by:
– The term of the contract
– Prevailing interest rates
– The level of upside potential
– Other market conditions
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Sales, Stop-Loss Orders, and Short Sales
• What these hedging techniques have in common is that
the owner of the securities continues to hold the
securities.
– All, or most, risk of loss (and opportunity for gain) on the
securities is transferred from the owner to someone else.
– The owner has effectively disposed of the securities, while
retaining nominal ownership.
– They also have the unfortunate consequence of triggering the
constructive sales rules.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Options, Futures, and Other Derivatives
• Derivatives are so named because they “derive” their
value in reference to the value of some other security
or property.
– These instruments do not represent an ownership interest in
the security or property.
– They provide investors with the right or obligation to buy or sell
securities or property or to receive payments based upon the
performance of some underlying security or property some
time in the future.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Nature of the Derivatives Markets
• The derivative markets are “zero-sum” games or
markets.
– A zero-sum game is one in which the average gain and loss of
all participants in the game is zero.
– Derivative securities do not represent any ownership interest in
anything.
– For every long position, there is a corresponding short
position.
– It is a negative-sum game due to commissions and transaction
costs.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Nature of the Derivatives Markets
• The concept of risk asymmetry refers to different risk
tolerances and capacities.
– Explains why investors invest in a negative-sum market.
– Investors with varying risk tolerance and capacity to bear risk
provide both liquidity and depth to the markets, making them
more efficient at pricing or valuing the underlying assets and
the cost of risk transfer.
– These markets are risk transfer mechanisms.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Nature of the Derivatives Markets
• Options markets are also a zero-sum game.
– Options contracts deal with the delivery of a specified amount
of some financial instrument, commodity, or other property at a
specified price (called the strike or exercise price) on (or before,
depending on the type of contract) some specified future date.
• The principal distinction is that options give one
side of the position the right, but not the
obligation, to buy or sell and the other side the
obligation to sell or buy if the other side exercises
his right.
• In futures markets, both sides of the transaction
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have the obligation to either buy or sell depending
Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Nature of the Derivatives Markets
• Derivatives are highly leveraged instruments.
– Investors have a great deal of flexibility.
• The markets are generally rather liquid and investors can take
offsetting positions with just pennies on the dollar relative to the
securities held long.
– The leverage is inherently risky.
• Investors may lose all of their initial investment, or more,
depending on the type of hedge and the instruments they use.
• Misuse of these instruments for hedging purposes can lead to
severe losses, far in excess of the original risk that was meant
to be hedged.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Nature of the Derivatives Markets
• The proliferation of derivative instruments stems from
a desire to “span” the market and to provide vehicles
capable of hedging many different types of risk in
addition to potential losses in appreciated positions.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Options, Spanning, and Synthetics
• A market or security is “spanned” if investors can
combine derivatives in that market or on that security to
reproduce the risk and return characteristics of the
underlying market or security.
– The creation of “synthetic” markets or securities
– The benefit of spanning is that it makes markets more efficient,
since investors will exploit price differentials in the “synthetics”
relative to the underlying market or security through arbitrage
and force all the instruments into price conformity.
• If an investor buys a call option giving him the right to
buy the stock, he is long in the call.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Options, Spanning, and Synthetics
• If an investor writes a call, collects the premium, and is
obligated to sell the stock if the buyer exercises the
option, he is short in the call.
• The long call position is equivalent to buying just the
upside potential of the stock above the exercise price.
– The short call position is equivalent to selling the upside
potential of the stock.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Options, Spanning, and Synthetics
• The profit profile of the long put position is equivalent to
buying the upside gain potential of a short position in
the underlying stock.
– The short put position is equivalent to selling the upside gain of
a short position in the stock.
• Any combination of a long call and a short put at the
same exercise price, even if different than the current
market price, together with a corresponding investment
in the risk-free asset to keep the total amount
equivalent, will be technically equivalent to owning the
stock outright.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Premiums
• The option premium is the amount one pays for an
option.
– The intrinsic value of an option is the amount by which the
option’s strike price is in-the-money.
• The intrinsic value of the option is the profit that could be realized
if the option was exercised immediately, and the underlying stock
was sold at fair market value (disregarding the cost of the option).
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Premiums
• The option premium is the amount one pays for an
option (cont’d).
– The speculative value of the premium is a function of several
variables:
•
•
•
•
The volatility of the price of the security
The length of the remaining term until the option expires
The dividend payout rate and timing of payments
The level of the risk-free rate appropriate to the remaining term
until the option expires
• How far in- or out-of-the-money the strike price is
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Premiums
• Generally, there are two kinds of options available for
most investors:
– American options
– European options
• The difference between the two is that American
options can be exercised before the expiration date.
– European options cannot
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Long Call:
– The purchase of a naked call option is a bullish strategy employed
when an investor thinks the market will rise significantly in the relative
short term (before expiration of the option).
– The downside risk is limited to the premium paid and generally no
margin is required.
– Can be used to increase the effective portfolio weights in those asset
classes that are underweighted until the investor can rebalance
• Short Call:
– Shorting calls is appropriate if the investor’s strategic view is relative
certainty that the market will not rise and he is unsure or unconcerned
about whether it will fall.
– The downside risk is unlimited.
• In the money calls
• Out the money calls
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Long Put:
– For investors with a bearish perspective on market conditions for the
underlying asset and who expect the market value of the underlying
asset to fall significantly over the term of the option.
– Maximum profit potential is the entire strike price of the stock less the
premium paid.
– Maximum losses are limited to the premium paid
• Short Put:
– Investors are virtually certain that the market will not go down, but thy
are unsure or unconcerned about whether it will rise.
– The profit potential is limited to the premium received.
– Potential loss is almost unlimited: the maximum loss is the strike price
of the contract minus the premium received
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Covered Call:
– A long position in the stock combined with a short call
• Same profit profile and characteristics as a short put
– Employed to increase income when investors expect the market price
of the underlying stock to fluctuate within a fairly narrow range over
the term of the option
– The upside potential at expiration is limited to the strike price minus
the market price of the stock
• Protective Put:
–
–
–
–
A long position in a stock combined with a long position in a put
Same profit profile and characteristics of a long call
The profit potential is unlimited.
The downside risk is limited to the premium paid for the put if the
stock position is entirely hedged by puts.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Bull Spread:
– A moderately bullish strategy investors may employ when they are
fairly certain that the market will not fall but want to cap the risk of loss.
– Investors sell an offsetting position that also limits their upside
potential
– Investors may implement the bull spread in two different ways:
• Bull Spread-Call
– Investor buys an in-the-money call and sells an out-of-the-money call
with strike prices roughly equally spaced below and above the current
market price of the stock
• Bull Spread-Put
– Investor buys an out-of-the-money put and sells an in-the-money put
option with strike prices roughly equally spaced below and above the
market price of the stock
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Bear Spread:
– Investors may employ this strategy when they think the market will not
rise, but they want to limit their risk of loss.
– Investors sell an offsetting position that also limits their potential gain.
– Investors may implement the bear spread in two different ways:
• Bear Spread-Call
– Investor sells an in-the-money call and buys an out-of-the-money call
with strike prices roughly equally spaced below and above the current
market price of the stock
• Bear Spread-Put
– Investor sells an out-of-the-money put and buys an in-the-money put
option with strike prices roughly equally spaced below and above the
market price of the stock
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Collar:
– A collar is a hedging strategy whereby an investor who wishes to
minimize potential loss in the value of a long equity position sells an
out-of-the-money covered call option and uses the premium received
to reduce or offset the cost of an out-of-the-money put option
• Limits the investor’s downside risk.
• The downside protection comes at the expense of foregoing some
potential upside gains.
• The maturity of a collar can range from several months to several
years.
– Both options may or may not mature simultaneously.
• Investors who have legal restrictions or practical limitations on
selling their stock may find collars useful.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Straddle:
– The investor thinks the market will be very volatile in the short-term or
a company is facing a situation that could greatly impact the stock
price, either up or down.
– A long straddle position rewards investors if the price moves
substantially up or down.
• Buying a call option and a put option with the same strike price
– Unlimited upside potential
– A short straddle is for investors who think that the market will be less
volatile.
• Selling a call and a put for the same strike price
– Limited upside potential; downside is unlimited
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Strangle:
– Used for the same purpose of a straddle
– Instead of buying or selling an at-the-money call and a put, the
investor buys or sells an out-of-the-money call and put
• Reduces the premium cost for the long straddle as well as the maximum
possible loss
– Loss is equal to the sum of the premiums on the long call and the
long put
• Upside potential is unlimited
• For the short strange, the lower premiums reduce the investor’s maximum
potential gain, which is equal to the sum of the premiums on the short call
and the short put.
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Butterfly:
– Another variation of the straddle which employs two additional out-ofthe-money options
– Long butterfly
• Investors add an out-of-the-money short call and an out-of-the-money
short put to the at-the-money long call and at-the-money long put of the
long straddle to reduce the net premium paid for the position
– Short butterfly
• Investors add an out-of-the-money long call and an out-of-the-money long
put to the at-the-money short call and the at-the-money short put of the
short straddle to limit downside rise
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
Option Strategies
• Calendar Spreads:
– Also known as time spreads
– Consists of opposing positions in two options of the same type
that have the same exercise price but expire at different times
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are the tax implications?
• Taxes are a key factor in evaluating how to most
effectively minimize risk in taxable portfolios.
• For hedging strategies, two primary rules govern
taxation:
– The constructive sales rules
• Govern when investors initiating a hedge position have to treat the
transaction as a sale of the hedged security even though no actual
sale has taken place
– The straddle rules
• Govern the tax aspects of closing a hedge position, including such
issues as tolling or freezing capital gain holding periods and
capitalizing the carrying costs
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Hedging and Option
Strategies
Chapter 41
Tools & Techniques of
Investment Planning
What are the tax implications?
• Constructive Sales Rules
– 1997 Tax Reform Act
• Provides that certain transactions attempting to neutralize future
gain and/or loss in a current appreciated stock holding are treated
as constructive sales
• Causes recognition of gain
– A constructive sale is a transaction in which the owner of an
appreciated security enters into one of the following three
transaction:
• A short sale of the same or substantially identical property
• An offsetting notional principal contract with respect to the same or
substantially identical property
• A futures or forward contract to deliver the same or substantially
identical property
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What are the tax implications?
• Constructive Sales Rules (cont’d)
– The term “substantially identical” is normally considered to be
securities issued by the same issuer, which are commercially
identical in all major aspects including dividend provisions.
• Correlated pricing in the market is the key test for
securities being considered substantially identical.
– Meaning that the prices move virtually in lock-step
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What are the tax implications?
• Initiating a put option purchase is not a constructive
sale
– An investor who purchases a put option should not have the
transaction treated as a constructive sale, even if the put option
is for a stock the put holder already owns.
• Out-of-the-money put options only reduce some of the potential
loss and none of the gain
• Must eliminate nearly all potential gain and loss to qualify
• A short sale on stocks or indexes not otherwise owned
is not a constructive sale.
– The shorted stock is not substantially identical to securities held long
in the investor’s portfolio.
– Selling short a stock or stock index already owned is a constructive
sale.
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What are the tax implications?
• Initiating a non-abusive collar should not be a
constructive sale or taxable event
– Creating collars that do not essentially freeze the value of the
stock within a relatively tight range should not trigger a
constructive sale of the underlying stock
– Generally, collars are unlikely to be considered abusive if the
term of the transaction is three years or less and the
difference between the floor and ceiling price is at least 20%.
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Avoiding Constructive Sale Treatment
• Investors are required to ignore the constructive sale
rules if they:
– Close the offsetting position prior to January 30th of the
following tax year and
– Retain their original position for at least 60 days after closing
the offsetting position
• They must go bare for that 60 days.
– Without entering into another offsetting position for that 60-day
period.
– If they enter into an offsetting position during that 60-day
period, the original constructive sale in the prior year is
reinstated.
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Straddle Rules
• The straddle rules include most situations where a
taxpayer is attempting to limit losses on an appreciated
security by owning another security.
– The Internal Revenue Code defines a straddle as “offsetting
positions with respect to personal property.”
• A taxpayer holds offsetting positions “if there is a substantial
diminution of the taxpayer’s risk of loss from holding any position
with respect to personal property by reason of his holding one or
more other positions (whether or not the same kind.”
– Test of intent to substantially limit risk of loss
– Straddle rules will apply to nearly any hedge that reduces the
investor’s potential for loss on an existing position within his
portfolio
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Straddle Rules
• Straddle occurs when an investor owns stock and then
enters in to an offsetting position such as:
– An option on such stock or substantially identical stock
– A position with respect to substantially similar or related property
• Property is substantially similar or related to stock when
the fair market value of the offsetting position primarily
reflects the performance of:
–
–
–
–
A single firm
The same industry
The same economic factors
Changes in the fair market value of the offsetting positions must
be reasonably expected to move inversely to the market value of
the position held.
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Straddle Rules
• If an investor is in a straddle position:
– The capital gain holding periods are suspended during the time
of the offsets
– Investors may take no current deduction for losses to the extent
of any unrealized gain in the offsetting positions.
• Losses on a straddle are deferred until unrealized gains on the
offsetting position are eliminated or realized.
– Investors must capitalize all carrying charges and interest
expense during the offset period and add them to the basis of
the long stock position.
• Reduces the amount of capital gain when the investor sells the
long stock position.
• Straddle rules may convert LTCG to STCG’s
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Economics of Primary Hedging Strategies
• The basic question is whether the economics merit a
hedging strategy considering:
– All relevant taxes
– The variety of potential price changes for the security or
portfolio to be hedged.
• Several possible outcomes should be modeled:
– Using various rates of appreciation and potential depreciation
– Considering taxation and other economics impacts such as:
• Lost opportunities for other investments
• Dividend income
• Transaction costs
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Where can I find out more about it?
•
•
•
•
•
•
•
The American Stock Exchange
Chicago Board Options Exchange
International Securities Exchange
Pacific Exchange
Philadelphia Stock Exchange
The Options Clearing Corporation
The Options Industry Council
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Tools & Techniques of
Investment Planning
Where can I find out more about it?
•
•
•
•
•
High Net Worth Investors and Listed Options
www.ffstudies.org
www.twenty-first.com
www.occ.treas.gov/handbook/invmgt.pdf
www.occc.treas.gov/handbook/deriv.pdf
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