used in this article may change as interest rates change.
When stock is hedged with a collar, the stock's
dividends are taxed at 35% instead of 15%. However, a new
hedging technology may be able to alleviate this burden. For
more information, contact Twenty-First Securities at
Investors with appreciated securities
often wish to hedge their positions.
Sometimes the goal is simply to protect gains and try to gather
additional profits; in other cases, the investor will also wish to
gain access to cash without currently paying tax.
Section 1259 of the Internal Revenue
Code sets forth conditions in which investors will be treated as
having constructively sold an “appreciated financial position” by
virtue of having hedged away too
much of the potential for gain or loss on the position.
Under the constructive sale rules, a hedging strategy must
retain some potential for profit or loss; otherwise, the strategy may
trigger a taxable event. While
the constructive sale rules rendered certain hedging tools obsolete,
other strategies remain viable.
The simplest hedging strategy involves
buying a put. A put gives
the investor the right to sell a stock at a given price; for example,
an at-the-money put gives the investor the right to sell the stock at
its current market price. The effect is to create a floor at that price.
At the same time, the investor’s potential upside for future
profit on the stock is unlimited. Unfortunately, as of this writing, at-the-money put options
typically cost 10-12% annually. This
cost makes them prohibitively expensive as a long-term hedging
Collars are a more cost-efficient way
to protect stock gains. An
options-based collar involves buying a put and simultaneously selling
a call. (A call is the opposite of a put. It gives the call buyer the right to purchase a given stock
at a given price). The
put creates a floor under the current price of the stock.
The call creates a cap over the current price.
Investors commonly use two types of
collars: zero-cost (or cashless) collars and income-producing collars. Zero-cost collars are the best strategy for a bullish
investor who believes that the underlying stock will continue to gain
value. These collars involve the purchase of a put and sale of a call,
with the strike price of the call set to generate exactly enough cash
to pay for the put. The
strategy allows the investor to costlessly hedge while still
maintaining potential for profit in the position.
Zero-Cost (Cashless) Collar
Income-producing collars represent a
more conservative approach. They
involve the purchase of a put and sale of a call with the call strike
price set relatively close to the current price of the underlying
stock. This lower strike
price generates cash in excess of that required to pay for the put.
However, it also “gives away” more potential for profit in
the collared stock. For
many investors, this drawback will be more than balanced by the
receipt of immediate cash, the “bird in the hand” theory.
An investor with a substantial holding
in one position can often monetize, or borrow against, the position to
raise capital. One
advantage of monetization over an outright sale is that monetization
does not produce a capital gains tax.
However, monetization does create interest expense.
It is possible for investors with
zero-cost collars to monetize against their underlying positions.
However, the combination of the two strategies is relatively
expensive because the zero-cost collar produces no income to
compensate for the monetization interest expense.
For this reason, investors should not adopt this approach
unless they are extremely bullish about the future of the underlying
security or the use of the borrowed funds.
The combination of monetization and an
income-producing collar represents a more appealing approach because
the income-producing collar produces cash to help offset the
monetization interest expense. So while monetization with a zero-cost
collar may demand an extremely bullish stance, the combination of
monetization and an income-producing collar may well represent the
most cautious approach to the management of low-basis positions.
Choosing the Best Strategy
Since the passage of the constructive
sale rule, collars have emerged as the most efficient way to hedge
low-basis stock. The two
basic collars (zero-cost and income-producing) should be appropriate
in many situations. However,
there are many other types of collars and, in addition to collars,
there are other ways to hedge and/or access cash from a low-basis
position. Each strategy
has different economic and tax implications, and investors should
tailor their approaches to their own particular circumstances.
For an overview of hedging and monetization scenarios,
investors can consult the decision tree on this web site.
For more detailed information about particular hedging tools,
investors should contact Robert Gordon, President of
Twenty-First Securities, by emailing
email@example.com or by phone at 212-418-6003.
article and other articles 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".