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November 29, 2005

Writing Off the Tax Man: The Tax-Smart Options Trader

By Mark Longo

Also in this article

  • Writing Off the Tax Man: The Tax-Smart Options Trader
  • Page 2

Writing a monthly column comes with quite a few perks. The most enjoyable of these perks is the opportunity to interact with you, the reader, on a regular basis. Your feedback has ranged from anti-options tirades to insightful commentaries on the state of the options industry. On balance, though, most of your emails contain detailed questions about complex option trading strategies. While I do my best to respond to these queries directly, a few of these questions are repeated so often that they cry out for a more elaborate response. In the interests of clarity, I will use this month's column to answer two of your most pressing concerns.

It seems that many of you are interested in the tax implications of options. This is an understandable concern. With day trading margins shrinking every day, most of you have been forced to ride ever larger and riskier positions just to break even. In the quest to safeguard your P/Ls, many have asked for help with a problem that is common among equity traders, brokers, private client managers, financial advisers and portfolio managers. The crux of the problem is: An equity position that you or your client has been riding for some time has finally realized a significant gain. Unfortunately, your holding period is not long enough to qualify for the long-term capital gains rate. At this point, most traders think that they only have two choices. They can either lock in their short-term profits or gamble and hold the position until it qualifies for the reduced tax rate.

But many of you have emailed me with a third choice. You want to know whether it is possible to use covered calls to roll short-term gains into long-term gains. The short answer is yes. However, it requires the innovative use of a very old options strategy. Before we proceed, there are a few caveats.

As with every other investment strategy on the planet, this technique involves some risk. It is possible that your position will lose some or all of its value during the rolling period. But, then again, what's life without some risk?

Taxing Structures

Traders, brokers, portfolio managers, etc. all operate under different tax structures. So this technique may not apply to you or your client's tax situation. Consult your firm's accounting department before attempting this approach.

Now that the legal part is out of the way, let's get to the heart of your question. Using covered calls to roll equity positions takes advantage of the fact that options come with an expiration date. Under most circumstances, equity traders take a dim view of option expiration dates. They tend to see them as needless layers of complexity piled on top of products that are already too complex. Still, in this scenario, the fact that options expire on a set date is a big advantage. When you write covered calls, you do not create a taxable event until you either buy them back or allow them to expire into stock. This little loophole has given rise to a very interesting tax minimization strategy. Here's an example: