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.
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.
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
Rules and Hedges:
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.
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
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”).
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.
Rules and Monetization:
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.
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.
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.|
and are not suitable for all
investors. Before engaging in an options
transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options".