Many investors with appreciated stock wish to protect their gains while making sure they don’t trigger a tax. An analysis by Twenty-First Securities shows that for stock acquired after 1983, the best hedge involves an options-based collar with the put and the call combined into one instrument.

Since the passage of the constructive sale rules, collars have emerged as the best way to hedge unrealized gains in stock. Collars involve the purchase of puts and the sale of calls.  With this strategy, the investor eliminates the potential for losses below the put strike price or profits above the call strike price. There are three ways to effectuate the economics of a collar: actual options, swaps, and variable forwards.

A key challenge for investors who acquired stock after 1983 is that if such stock is hedged with a collar, it is subject to the straddle rules. Two significant repercussions follow from these rules. The first affects all investors who hedge post-1983 stock using collars. The other affects only investors who borrow as well as hedge.

Straddle Rules and Hedges:

If a position is deemed to be a straddle, the losses realized on any leg of the collar cannot be deducted until all positions are closed, but profits are taxable immediately as short-term capital gains at a rate of 35%.  As a result, any future option transactions could create a whipsaw of phantom taxable profits.

For example, suppose that XYZ is selling at $100 per share.  The investor constructs a three-year zero-cost collar on the stock, buying puts struck at $90 for $14 and selling calls struck at $160 for $14.  If the collar expires with the stock price between 90 and 160, then the investor faces a tax of $4.90 (35% of $14) on each expired call; at the same time, however, the investor cannot currently deduct the “wasted” $14 cost of the puts. The investor has created economic protection and some potential for profit, but the after-tax cost is almost $5 per share (with no actual profits realized).

Suppose that instead of buying separate puts and calls, the investor hedges XYZ by employing a one-contract collar.  With this approach, the investor could create the same economic structure – i.e. effectively buying puts at $90 and selling calls at $160.  But when a zero-cost collar is constructed using one option, the price of the option is zero.  Thus if the collar expires with the stock price anywhere between $90 and $160, the expiration would not create any taxable income or loss.  The investor has created the same level of economic protection and potential for profit, but without incurring any additional tax burden.  (For more on zero-cost collars, see “Hedging Basics”).

Investors can create one-contract collars using any of the three basic collar strategies. If the investor uses actual options, they must be traded over-the-counter because listed puts and calls are always traded as separate entities, whereas over-the-counter options can combine puts and calls into one instrument. If the investor uses swaps or variable forwards, then the embedded put and call will also offset each other.

Straddle Rules and Monetization:

In addition to hedging, many investors with appreciated stock wish to withdraw money from their positions.  Such investors may choose to monetize, or borrow against, their appreciated stock.  Borrowing creates interest expense.  If the borrowing cost occurs in conjunction with a straddle, then capitalization rules might apply.  Under the terms of the most recent proposed regulations (which reflect the government’s recent rulings), if collared shares are used as the exclusive collateral for a loan, the interest would need to be capitalized.  Because of this “direct tracing” rule, if an investor has other liquid securities to post as collateral, it would still be possible to deduct the interest expense.  For example, suppose an investor with $100 of hedged shares were to borrow and re-invest in $100 of securities and leave only these positions in the account; in that case, 50% of the interest expense would be currently deductible while the remaining 50% would need to be capitalized.

Investors can monetize with any of the three basic hedging strategies by borrowing against the hedged position.  Swaps produce ordinary income, which makes them less efficient in terms of taxes.  In certain cases, Federal Reserve rules limit investors’ ability to monetize with options-based collars.  For this reason, and through the force of general usage, many investors wishing to borrow rely on prepaid variable forward contracts. However, with this strategy, the nature of the contract automatically captures all carrying costs as capital losses rather than interest expense.  As a result, investors who use this tool may never be able to deduct the carrying charges.  In the analysis of Twenty-First Securities, this approach is too expensive in terms of taxes.

If an investor employs a variable forward, it should not be prepaid; rather, the monetization should be effectuated through a separate borrowing (just as it would be with a swap or one-contract option). Indeed, the only time a variable forward should be prepaid is when Federal Reserve rules prevent the investor from using other strategies to monetize.  In almost all cases, investors wishing to monetize should employ either an options-based collar or a variable forward that is not prepaid.

For an interactive overview of hedging and monetizing possibilities for different types of appreciated securities, see low-basis stock hedging decision tree.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".