Tax Deferral Using Options

First of all, let me preface this post with the disclosure that I am not an accountant, and it is always best to consult with one before making any investment related decisions pertaining to taxation. That said, many Canadian investors have been benefiting from a healthy bull market with nothing more than the odd hiccup in the S&P/TSX Composite since July of 2013. Few sectors have performed as well as the Canadian banks.

Let’s take a look at TSE:ZEB which is the BMO S&P/TSX Equal Weight Banks Index ETF. This exchange traded fund represents the value of an equal number of shares held in the 6 top Canadian banks. As of August 21st, 2014 the holdings are as follows:

Below is a weekly chart reflecting the strong uptrend in the TSE:ZEB.

Investors who took a position at the beginning of the year are up just over $3.00 per share or approximately 15%. The consideration at this point is how to insure that this healthy profit is not lost as we move towards the end of the year. While there is the potential for the banking sector to continue to appreciate, the potential for a healthy “correction” is always present and becomes an increasingly higher probability the more the shares continue to trend higher.

For an investor that is holding a position in a non-registered account the dilemma may be two-fold. The first consideration, should profits be taken at the risk of losing the benefit of further upside? The second is, that if the shares are sold, a capital gain will have to be realized for this year, which may not be in the investors best interest.

So how do you resolve this issue?

An investor who has limited expectations for further upside on a stock and wishes to lock in the profits generated at minimal cost can use a Collar strategy. The Collar involves the sale of a call against the shares held and the purchase of a put. In essence you are combining the Covered Call strategy with a Protective Put.

Since the investor does not wish to sell their shares this year, the strategy can be constructed using options expiring in 2015.

For example:

Currently, only March 2015 options are listed for TSE:ZEB

Prices are as follows:

TSE:ZEB shares – $24.40

March 2015, 25 strike Call – $0.35 Bid

March 2015, 24 strike Put – $0.85 Ask

The investor would collect $0.35 per share for the call write and use the credit to pay for a portion of the $0.85/share cost of the put. The net cost of the Collar is $0.50/share.

With the Collar in place, the investor cannot make any gains beyond $25.00. If the shares are trading above this on the third Friday of March, 2015 the stock will be called away. Including the cost of the Collar, this is still a 15% profit. Keep in mind that the position can be offset in January despite the later dated expiration if the investor wishes to sell the shares and lock in the profits in the new year.

The intention of the strategy is to insure that the profits are protected. This is where the Protective Put comes in to play. The investor has the right to sell the shares at $24.00 regardless of how low they may drop. With the shares of the stock at $24.40 and the cost of the protection reduced to $0.50, the maximum loss on the position is now limited to $0.90.

Regardless of how low the shares drop, the investor has locked in a $2.10 ($3.00 profit – $0.90 Collar cost) or 10% profit into the new year. This can also be offset in January if this meets the investors objective.

The result

worst case, a 10% profit and best case, a 15% profit for holding the position into the new year.

Things to consider

There may be a little more upside to the Canadian banks leading into the fall. With this in mind, it may be appropriate to just add a protective put expiring in December. It will cost a little more for the protection, but the investor will participate in any continued upside while locking in profits. As we move closer to the year end, the January options will become available and a Collar could be constructed at that point to carry the position through to the new year. Food for thought as we enter the final quarter of 2014.