"Synthetic" Equity Positions
Many investors have unrealized
profits in positions they can’t actually sell, such as employee
stock options, restricted stock or shares in private hedge or venture
capital funds. When
the stocks underlying these positions gain value, such investors
may wish to lock in profits but believe they cannot do so without
holding the actual shares. In
most situations, however, it is possible for investors to create
hedges that protect their holdings.
Passive Investments in
One common type of synthetic
holding involves interests in private hedge or venture funds.
Passive investors in these funds usually cannot make
investment decisions for the funds.
However, a passive investor may enter into completely
separate personal investments to protect his or her share of a
fund’s profitable position.
This strict separation of the two holdings has interesting
One possible hedge would involve
short sales. A short
sale is a sale of a stock the investor does not own.
If the stock goes down, the short seller will make money,
and if the stock goes up, the short seller will lose.
Therefore, a short combined with the indirect ownership
should create an economic situation that is similar to a sale.
From a tax perspective, this approach might appear
problematic, because when a fund investor does a personal short
sale of a fund holding, the combination of the personal hedge and
the holding in the collective investment will include all the
elements of a short against the box.
A short against the box often constitutes a constructive
sale. In this
situation, however, if the investor has no control over the
disposition of the long stock in the fund, and if the short
position is kept strictly separate from the fund, then the
combined holdings should not constitute a constructive sale for
Certain caveats apply to this
investor can’t directly or indirectly own more than 50% of the
fund; otherwise, the combined positions will constitute a
constructive sale. Moreover,
the strategy is only available to investors whose role in the fund
is strictly passive; if an investor has control over fund
decisions, then the strategy might constitute a constructive sale. Finally, this strategy requires collateral.
Restricted stock presents different
problems, but several techniques are available to manage the risk
in such positions. Under
Rule 144, hedges on restricted stock do not stop the holding
period clock, but investors should take care to ensure that their
hedges are not constructive sales.
For more discussion of hedges for restricted securities,
readers should review
Protection For Restricted Holdings in the May 1999 issue of Tailored Solutions.
Employee Stock Options
Employees with employee stock
options can often hedge the positions with “regular” options,
forwards or swaps. However, options and forwards can create a whipsaw.
The reason is that income on employee stock options is
ordinary income, while income on regular options or forwards is
capital in nature. If
the stock increases after the hedge is put on, then the hedge will
work in economic terms but not in terms of taxes.
The investor will gain value on the employee options and
lose value on the hedge position, creating ordinary income on the
employee options and capital loss on the hedge.
The ordinary income will be taxable at 40%, and the capital
loss will be limited in its deductibility, like any other capital
loss. For this
reason, swaps are the safest way to hedge employee options.
Income and loss on swaps are treated as ordinary, so they
can always be allocated against income or loss on the employee
Investors with employee options
should be aware that these options are different from stock in
that they have no margin or collateral value.
Therefore, a hedge on these options usually requires
appropriate margin or collateral from sources other than the
options themselves. For
large positions involving a cooperative issuer/employer, the
employee options may be “converted” into a marginable
converted marginable security can then be used to satisfy the
margin or collateral requirement.
Investors with employee stock
options should also keep in mind that “affiliates” cannot
short and can only buy a put or sell a call if they are long the
same number of underlying shares. A holder of unexercised employee stock options generally is
not considered to be long for these purposes.
However, even for affiliates, there are risk management
who are interested in exploring this issue should contact
A Complex Analysis
The hedging of non-physical equity
positions can be somewhat complicated.
Investors need to apprise themselves carefully of the
effects of potential hedging transactions before they proceed.
In many situations, however, a viable hedge can be
constructed to protect holdings without triggering any tax.
For an interactive overview of
hedging and monetizing possibilities for different types of
appreciated securities, investors can consult Twenty-First
Securities hedging low-basis
stock decision tree.
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".