least 100,preferably 500.
■
Put Strike—One strike OTM (lower than current stock price).
■
Call Strike—One strike OTM (higher than current stock price).
■
Expiration—Any time period can work, though remember that the Long Putwill suffer from time decay, particularly in the final month to expiration, so it’sbest to choose expirations of two months or more. Use the same expiration forboth legs.
7.11.3 Risk Profile■
Maximum Risk
[Uncapped]
■
Maximum Reward
[Lower strike  net credit] (or less net debit)
■
Breakeven
With net debits: [lower strike  net debit]With net credits: [higher strike  net credit]
Synthetic Strategies
7.11.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock pricefalls, we make profitsand vice versa.
DeltaDelta (speed) is negative, indicating thestrategy’s bearish bias.Remember, you’realmost replicating ashort stock positionhere, so Delta veers to1 per contract whenthe stock price isdeep ITM or OTM.GammaGamma (acceleration)peaks outside thestrike prices. Noticehow Gamma is neutralin between the strikes.
Risk Profile
Theta
ThetaTime decay is helpfulwhen the position ismaking losses andgenerally harmfulwhen the positionruns into profit.
Delta
Vega
VegaVolatility is generallyhelpful when the position is profitable andharmful when it ismaking losses.
Gamma
Rho
RhoRho is negative andconstant. As with theother Greeks, in relation to this strategy, itis relatively meaningless.
7.11.5 Advantages and DisadvantagesAdvantages■
Create something similar to a short stock position with virtually zero capitaloutlay and the ability to leg in and out of the call or put as appropriate.
■
Capped risk down to the stock falling to zero (though this could equally bedescribed as being uncapped risk as the stock falls to zero!).
■
Uncapped profit potential if the stock appreciates.
Disadvantages■
No leverage or protection created by the position.
■
Uncapped risk potential if the stock rises.
■
Bid/Ask Spread can adversely affect the quality of the trade.
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7.11.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your puts andbuying back the calls.
■
You can also exit just your profitable leg of the trade and hope that the stockmoves to favor the unprofitable side later on. For example, if the share hasmoved decisively downwards, thus making the Long Puts profitable, you willsell the puts and make a profit on the entire trade, but you will be left withalmost valueless Short Calls. Having now sold the puts, you will secure yourposition by buying back the depleted calls.
Mitigating a Loss■
Sell the position if the stock rises up through your predetermined stop loss.
7.11.7 ExampleABCD is trading at $35.10 on June 2, 2004.Buy August 2004 30 strike puts at $0.90.Sell August 2004 40 strike calls at $1.00.Net Credit
[Sold call  bought put]$1.00  $0.90  $0.10
Maximum Risk
Uncapped
Maximum Reward
[Lower strike  net credit]$30.00  $0.10  $30.10
Breakeven
[Higher strike  net credit]$40.00  $0.10  $40.10
7.12 Long BoxProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Capped
Capital Gain
!
Expert
Neutral
High
■ Short Put■ Long Call■ Long Put■ Short Call
Capped
Synthetic Strategies
7.12.1 DescriptionThe Long Box is a complex strategy that can (in some jurisdictions) have beneficialeffects for tax planning from year to year. If your incentive for this strategy is a taxplay, you should consult with your tax advisor beforehand to evaluate whether ornot it is valid where you live.The strategy involves creating a lower strike Long Synthetic Future and countering it with a higher strike Short Synthetic Future. The long and short positions cancel each other out, and we’re left with a straight horizontal line. The trick is to ensurethat the sum of our net purchases is less than the sum of our net sales in order tomake a profit. Remember, there are four legs in this strategy, two longs and twoshorts, and the strategy is typically a net debit because we’re buying ITM optionsand selling OTM options.Some traders who are sitting on vast capital gains will seek to close out the lossmaking legs of the strategy just before the end of the tax year, thereby setting offthose losses against their gains and reducing their capital gains tax bill for that year.However, we need to remember that any open short positions are generally treatedas 100% gains until the position is closed.High volatility is good for the Long Box, particularly if we’re looking to conductthe type of trade outlined previously, where we leg in and out. Ideally, we want a bigfall followed by a big rise, or vice versa, and we leg out in accordance with our original motivation for doing the trade in the first place.
Sell lowerstrike put
Buy samestrike call
Buy higherstrike put
Sell samestrike call
Long Box
Steps to Trading a Long Box1. Sell one lower strike (OTM) put.2. Buy same strike (ITM) call.3. Buy one higher strike (ITM) put.4. Sell same strike OTM call.Steps In■
Identify clear areas of support and resistance that the stock, being volatileenough, will fluctuate between.
Steps Out■■
Manage your position according to the rules defined in your Trading Plan.
Remember that the Long Box is a combination of other strategies, so it canbe unraveled in two-leg chunks.■ You can unravel the position as parts of the trade become profitable or lossmaking. Remember for tax purposes that a short option is taxed as a 100%gain until you buy it back to close the position, so this position should behandled with care, and professional advice is highly recommended.
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Never hold the long options into the last month before expiration.Remember to include all the commissions in your calculations.
7.12.2 ContextOutlook■
With long boxes, your outlook is direction neutral. You expect a lot of movement in the stock price, preferably between definable areas of support andresistance.
Rationale■
With long boxes, you are looking to execute a form of arbitrage where theprofit is assured, known, and unaffected by market moves.
■
You are volatility neutral per se, but there can be potential tax advantages tolegging out of the loss-making side first. Professional advice is a must here.
■
If you examine what you’ve done here, you have simply combined a LongSynthetic Future with a Short Synthetic Future at a higher strike. These twocombined effectively cancel each other out, and the idea is to capture a profitdue to mispricing in the market.
Net Position■
This is typically a net debit trade because we’re buying ITM options andselling OTM options.
■
Your maximum risk is the net debit or net credit less the difference between thestrikes. Your maximum reward is the same. With this trade, you can only haveone or the other.
Effect of Time Decay■
Time decay is generally helpful because you take your maximum profits atexpiration.
Appropriate Time Period to Trade■
It’s preferable to trade this strategy on a medium-term basis, preferably aroundthree months, in order to accommodate large swings in price.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Identify clear areas of support and resistance that the stock, being volatileenough, will fluctuate between.
Synthetic Strategies
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower Strike—Create the Long Synthetic Future element below the currentstock price.
■
Higher Strike—Create the Short Synthetic Future element above the currentstock price.
■
Expiration—Preferably around three months or less. Use the same expirationdate for all legs.
7.12.3 Risk Profile■
Maximum Risk
[Net credit received or net debit paid]  [Differencebetween strikes]
■
Maximum Reward
[Difference between strikes]  [Net credit received or netdebit paid]
■
Breakeven
N/A
7.12.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileThe Long Box willeither make a certainprofit or a certain lossif all legs are closedsimultaneously.
DeltaDelta (speed) is zero.
GammaGamma (acceleration)is zero.
Risk Profile
Theta
Delta
Vega
Gamma
Rho
ThetaTime decay is generally helpful becausewe take our maximumprofits at expiration.
VegaVolatility does notaffect the tradebecause your profitsare locked in andstatic.
RhoHigher interest ratesare generally unhelpful because you havelocked in your profitsand are waiting totake them.
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7.12.5 Advantages and DisadvantagesAdvantages■
Can be used as a tax hedge if entered and exited correctly either side of a taxyear.
■
Should be placed in such a way to be virtually risk-free, although as a taxhedge, you’d need to leg out in stages.
■
Can be used to create an arbitrage opportunity.
Disadvantages■
Requires a large number of contracts to be worth doing.
■
Complicated trade requiring the assistance of your broker or accountant.
■
Bid/Ask Spread can adversely affect the quality of the trade.
7.12.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back theoptions you sold and selling the options you bought in the first place.
■
Advanced traders may leg up and down or only partially unravel the spreadas the underlying asset fluctuates up and down. In this way, the trader will betaking smaller incremental profits before the expiration of the trade.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-legand create alternative risk profiles. There is no point in doing the trade unlessyou have locked in a certain profit, or unless you have another reason forlocking in a deliberate loss.
7.12.7 ExampleABCD is trading at $34.92 on June 2, 2004.Sell August 2004 30 strike puts at $1.00.Buy August 2004 30 strike calls at $6.00.Buy August 2004 40 strike puts at $6.20.Sell August 2004 40 strike calls at $1.20.
Synthetic Strategies
Net Debit
[Bought options  sold options]$12.20  $2.20  $10.00
Maximum Risk
[Net debit  difference between strikes]$10.00  $10.00  $0.00
Maximum Reward
[Difference between strikes  net debit]$10.00  $10.00  $0.00
Breakeven
N/A
So, in this real-life trade, we can make neither a profit nor a loss! But, by legging outas the stock price fluctuates, we may be able to make incremental profits when weclose each leg or set of legs.
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8Taxation for Stock andOptions TradersIntroductionU.S. tax laws concerning trading, and options in particular, are absurdly complicated, so to avoid many sleepless nights, you should hire a decent tax consultant foryour annual investment P&L.In this chapter, we’ll attempt to uncover some of the mysteries of the U.S. tax system; however, the summaries are meant to highlight the complications of the rulesand steer you toward the appropriate professional advice.Overall, it’s sound practice to concentrate on perfecting your Trading Plan firstand worry about the tax later. On the whole, we shouldn’t mind paying tax on ourtrading activities because typically this means that we’ve been profitable.Unfortunately, the authorities do seem to indulge in a “heads-we-win, tails-youlose” mentality, whereby your losses will be offset at unfavorably low rates and yourgains will be charged at unfavorably high rates wherever possible!The main purpose of this book is to explain the strategies themselves. Having asound and well-rehearsed Trading Plan is the key to our success. We can becomeproficient at playing just one stock, chart pattern, or indicator. The best traders aretypically great at one or two things, upon which their Trading Plan is constructed.Specialization is vital to your trading success because it gives you clarity of thoughtfrom the planning stage right through to the execution process. If you trade well,then you can “enjoy” paying the tax advisors . . . and even the tax. Ultimately, taxis a headache well worth having because in most cases it means you’re makingmoney!
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8.1 Tax on Stocks8.1.1 Simple Capital Gains TaxIn the U.S., taxation on capital gains comes into two categories:■
Long-term gains for those assets held over one year.
■
Short-term gains for those assets held for less than one year.
Long-term gains are taxed at 15% and short-term gains at 35%.
Short-term capital lossescan be netted off long-termcapital gains. The net (gain)is taxable at 15%.
Time Asset Held
Tax Treatment
Tax Rate %
> 12 months
Long term
15%
< 12 months
Short term
35%
Example 8aJanuary 20, 2003January 20, 2004
You buy 1,000 shares of ABCD at $20.00 ➞
$20,000
You sell 1,000 shares of ABCD at $25.00 ➞
$25,000
Gain ➞
$5,000
Deemed a long-term investment; therefore, tax rate  15%
Example 8bJanuary 20, 2003January 18, 2004
You buy 1,000 shares of ABCD at $20.00 ➞
$20,000
You sell 1,000 shares of ABCD at $25.00 ➞
$25,000
Gain ➞
$5,000
Deemed a short-term investment; therefore, tax rate  35%*
* Short-term capital gains are taxed at your marginal rate. For higher-rate taxpayers,this is 35% in the U.S., although this is scheduled to rise in 2010.
So far, so good . . . but that’s about as good as it gets! From now on, things begin toget more complicated.
Taxation for Stock and Options Traders
8.1.2 Shorting StocksWhen you short an asset, the mechanism involves your broker borrowing the stockin order for you to “sell” it without having owned it in the first place. In order toreverse the position, you effectively buy back the asset that you sold short.There are times where we may have multiple positions open on the same security or index. Why could this be the case? Well, we could be long a stock on the weekly chart but also doing a short-term positional trade on the dailies. Whatever thecase, it’s possible for us to have both long and short positions on the same security.For these types of situations, regardless of how we’re classifying the individualtrades, the tax classification may conspire against our better interests by treating thelong and short positions of the same security as “constructive sales.”
Example 8cJanuary 20, 2004
You buy 1,000 shares of ABCD at $20.00
March 18, 2004
You short 1,000 shares of ABCD at $25.00
Even though you may have meant to keep two open positions on this stock (onelong position and one short position), this sequence of transaction could be treated as a constructive sale, and you may be liable to short-term capital gains tax onthe $5,000 “gain.” The treatment will depend upon the timing of the two transactions, price differentials, and how you close each position, though it is not straightforward.
8.1.3 Wash Sales (or Bed and Breakfast)Many tax authorities have wizened up to the investors’ attempt to mitigate their taxgains by making the most of their losses. For example, say you have an investmentportfolio of several stocks, but you are sitting on a pile of losses on one particularstock that you want to retain for the medium to long term. What you would do issell the loss-making stock to take advantage of those losses now and buy it straightback the next day (or soon afterwards). In the old days, if you did this towards theend of a tax year, you could utilize those losses and set them off in that tax yearagainst your other profits.Unfortunately the benefits of bed and breakfasting have been eliminated allaround the world in various ways. In the U.S., if you own stock, sell it, and then buyit back within 30 days, this is considered to be a “wash sale.” The capital loss is notrecognized and therefore cannot be set off against other gains.How would you attempt to get around this? By selling a naked ITM put, whichwould mean you’d own the stock again as soon as you’re exercised. Alas, the “washsales” rule covers this practice too, though its precise mechanisms need to be examined by your tax advisor, as do other options scenarios.
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8.2 Tax on Options8.2.1 Long OptionsFor capital gains tax, long (owned) options are treated the same way as describedpreviously in terms of long-term and short-term gains or losses. The activation of achargeable gain/loss is triggered either by the disposal or the expiration of theoption.Three things can happen when you buy an option:1. It expires OTM and therefore is worthless, meaning a 100% loss.2. You sell the option for a profit or a loss.3. It expires ITM and you exercise your right to buy (call) or sell (put) the underlying asset.These three situations give rise to different taxation situations:1. If the option expires OTM, it is worthless, meaning you have made a 100%loss. In the absence of another related position, you would be able to set offthat 100% loss against other gains.2. If you sell the option for a profit or loss, you will be subject to the long-term orshort-term capital gains rules as set out earlier, depending on whether youheld the option for more than 12 months.3. If you exercise a call option, then you will be buying stock. The cost of the calloption you bought is added to the strike price at which you’re buying thestock, and the holding period for the stock starts on the day after exercise.
Example 8dAugust 20, 2003
You buy ten $30.00 strike LEAP call option contracts of ABCDstock expiring in January 2005 for $5.00.
January 21, 2005
The stock is worth $40.00, meaning your call option expires with$10.00 of Intrinsic Value. This is a profit of $5,000 on your originalinvestment that you made 17 months ago (i.e., far enough away tohave made this a long-term investment).Instead of selling the option the day before expiration and making$5,000 profit with only 15% tax to pay, you decide to exercise theoption.This means you now own the stock at $30.00 (the strike price), plusthe $5.00 you paid for the LEAP call option; i.e., a net cost of $35.00.However, the holding period of the stock is deemed to begin theday after exercise, meaning the clock only starts on January 22, 2005.This means that until January 22, 2006, this is deemed to be a shortterm investment, taxable at 35%. If you decided to sell the stockwhile it was still at $40,000, you’d still make your $5,000 profit, butyou’d be paying 35% on that, as opposed to the 15% you’d havepaid if you’d simply sold the option the day before expiration. That’s$1,000 of your profit wasted by not understanding the tax situation.
$5,000
Taxation for Stock and Options Traders
4. If you exercise a put option, then you will be selling stock. The cost of the putoption you bought is subtracted from the strike price at which you’re sellingthe stock, and the holding period for the position starts on the day afterexercise.
8.2.1.1 Exercising OptionsWhen we exercise an option early, we forego any time value that is remaining within the option premium. Typically this would be a naïve thing to do. However, beingaware of the intricate tax provisions enables us to consider possible occasions whereearly exercise may be beneficial.
Example 8eJune 2, 2004
You buy ten $20.00 strike call option contracts of ABCDstock expiring in January 2005 for $5.50.
December 21, 2004
The stock price is now $30.00. Your calls are worth $11.00with one month left to expiration. Your unrealized profit is$5.50 ($5,500 in real dollars).
$5,500
You’re happy with the profit, but you want to hold the stock forthe long term and defer the tax on the profitable option trade.January 20, 2005
ABCD shares are still at $30.00, but the option is now onlyworth $10.00 (time value has evaporated). You exercise yourright to buy 1,000 ABCD shares at $20.00.The basis for tax on the stock is now $20.00 plus the $5.50 youpaid for the call option. The clock starts on your new investmenttomorrow. Now you have to wait until January 21, 2006 in orderfor the profit to be taxed at the lower (long-term investment) rate.
Was the wait worth it? Well, only the future action of the share price will tell. If itcontinues to rise, then that 20% tax differential between short- and long-term investments may become substantial. If ABCD falls, then you may have forfeited a perfectly decent profitable trade purely in order to save yourself some tax.In summary, the rule is don’t let the tail wag the dog. Unless there is a spectacular reason to do otherwise, base your investment decisions around your TradingPlan. Base your Trading Plan around fundamental, technical, news, options and anyother indicators you feel are appropriate. Certainly be aware of tax implications, butdon’t let tax get in the way of a coherent trading plan.
8.2.2 Short OptionsIn the U.S., short options are not taxable when the position is opened. Closing theposition (or the expiration of the option) always creates a short-term gain or lossregardless of how long the position was open. In other words, even if you shorted
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an option with over 12 months left to expiration, and it expires worthless, you’reliable to a short-term capital gains tax liability. Outside the U.S., shorting a positioncan incur an immediate chargeable gain.Short Calls
If a call is exercised, the writer is obliged to deliver the underlying stock. The capital gains tax for the short stock position is based on the strike price plus the premium received.Short Puts
If a put is exercised, the writer is obliged to buy the underlying stock. The capitalgains tax for the long stock position is based on the strike price plus the premiumreceived. Note that the stock holding period (for tax purposes) starts the day afterexercise.
8.2.3 Offsetting PositionsConsider a Straddle.
Example 8fDecember 21, 2004
ABCD is priced at $25.00. There’s an earnings report due in fivedays, and you’re convinced there’s going to be a surprise. You’renot sure which way the market will respond, only that there’ll be asignificant jump either way. You buy a $25.00 strike March 2005Straddle, paying $2.45 for the calls and $2.15 for the puts, meaninga total investment of $4.60.
December 31, 2004
Earnings were a bonanza, and the Street was completely caughtby surprise. ABCD shares have jumped $10.00 to $35.00, and yourStraddle has more than doubled in value.
$5,500
Your puts are now worth only $0.15, and your calls are worth$12.15.If you sold your puts, you’d expect to be able to claim the $2.00loss in this tax year. If you hold onto the calls, you’d expect to paythe CGT on those gains in the next tax year. The problem is thatthe IRS considers the two legs of the Straddle as “offsetting” eachother. Therefore, you will not be able to benefit from the loss youmade on the put until you close the other side of the straddle; i.e.,the profitable calls.
The rules of Offsetting Positions state that where two positions offset each other tocreate substantial diminution of risk, then certain tax restrictions apply to the settingoff of one side’s losses against the other side’s gains. This rule is vital to understandif you’re considering a Long Box strategy, which in certain cases can be used as abrilliant tax strategy, depending on the tax legislation of the jurisdiction you’retrading in.
Taxation for Stock and Options Traders
8.2.4 Synthetic Call (Also Known as a Married Put)With this strategy, you’re insuring the purchase of stock by also acquiring a put. Thebought put caps your losses in case the stock descends into freefall, but it adds to thebasis cost of the trade.For tax purposes, if the stock and put are acquired on the same day, then the position is taken as a whole. If the put expires, then the premium is added to the costbasis of the stock. Regarding the Offsetting rules (described previously), there is stillsome uncertainty as to the treatment of this strategy.
8.2.5 Covered CallsBeing such a popular strategy, we might hope and expect the tax rules concerningcovered calls to be easily interpreted and straightforward. No such luck! In the U.S.,the taxation rules governing covered calls are complicated and require considerableanalysis.
8.2.5.1 Qualified StatusCovered calls are categorized as either “Qualified” or not qualified. “Qualified” status means that, for tax purposes, the stock may be considered a long-term investment if the appropriate conditions prevail. Unqualified covered calls result in thestock being taxed as a short-term investment as far as gains are concerned.The determination of “Qualified” status for a Covered Call is dependent on thefollowing criteria:■
Time to expiration.
■
The strike price in relation to the stock price, where the strike price is In theMoney (ITM).
Out of the Money (OTM) Covered Calls
Writing OTM covered calls presents no complications and does not affect the statusof the stock. Therefore, if you hold the stock for more than 12 months, writing OTMcalls along the way, when you come to sell the stock, it will be considered a longterm investment and gains will be taxed at the long-term investment rate.In the Money (ITM) Covered Calls
Complications arise with ITM covered calls. As mentioned, there are two main criteria governing “Qualified” status: time to expiration and strike price.Generally, “Qualified” status relies on the fact that:■
The option must have more than 30 days to expiration.
■
The strike price must be the first available strike below (ITM) the stock’sclosing price the day before the trade was entered.
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Example 8gJune 2, 2004
You buy 1,000 shares of ABCD stock at $36.50 and sell ten $35.00 strike July calls.Is this Qualified or not?■ Days to expiration > 30.■ The strike price is the first available strike below $36.50.
Therefore, this does qualify as a Qualified Covered Call.
Example 8hJune 2, 2004
You buy 1,000 shares of ABCD stock at $36.50 and sell ten $30.00 strike June calls.Is this Qualified or not?■ Days to expiration < 30.■ The strike price is not the first available strike below $36.50.
Therefore, this does not qualify as a Qualified Covered Call.
However, where there are more than 90 days to expiration, the rules become evenmore confusing, and this requires a table for explanation.
Table 8aIn the Money “Qualified” Covered CallsPrevious Day Stock Close
Time to Expiration
Lowest Qualifying Strike*
Less than or equal to $25.00
More than 30 days
One strike below previous day stock closeunless strike is less than 85% of the stockprice.
$25.01 to $60.00
More than 30 days
One strike below previous day stock close.
$60.01 to $150.00
31–90 days
One strike below previous day stock close.
$60.01 to $150.00
More than 90 days
■ Two strikes below previous day stock
close.■ Not more than $10.00 ITM.
Greater than $150.00
31–90 days
One strike below previous day stock close.
Greater than $150.00
More than 90 days
Two strikes below previous day stock close.
* If the opening stock price on the day the option is written is more than 10% higher than theprevious day’s close, then the opening price is used to determine the lowest acceptablestrike price.
Taxation for Stock and Options Traders
Example 8iDecember 21, 2003
You buy 1,000 shares of ABCD stock at $36.50.
October 20, 2004
ABCD is now at $40.00. You write a $30.00 strike January 2005call for a $13.50 premium.
$36,500
This is an unqualified covered call now.January 21, 2005
With ABCD still at $40.00, the ITM $30.00 strike call isexercised.At what rate are you taxed?Well, you held ABCD stock for 10 months before you wrote anITM call against it. Because the position was unqualified, yourstock holding period was suspended at 10 months. When thewritten ITM call is exercised in January, for tax purposes, thestock holding period is still suspended at 10 months, eventhough you’ve actually held the stock for 14 months. Therefore,the prof