Using Options as a Tax Deferral Strategy

Over the last 2 days I have had the opportunity to speak at the Options Conference in Toronto and Montreal. The conference brought together the top industry professionals from across North America with a focus on the use of options for Investment Advisors and Portfolio Managers. It was a phenomenal opportunity to hear some the great investment minds discuss the different approaches to adding value to their clients through using options. In particular, it was interesting to note how these managers differentiate themselves in a sea of competition.

During my 2 hour presentation, I had the opportunity to cover many different strategies professionals could utilize, but I wanted to further elaborate on the strategy of using an options collar as a tax deferral strategy.

For those unfamiliar with the strategy, it involves the buying of a put and the selling of a covered call against a stock you or your client already own. For any need to seek tax deferral, the stock position needs to meet some basic criteria:

1. You or your clients are making considerable capital gains on a stock or ETF.
2. You or your clients are looking to take the profit.
3. From a time frame perspective, it is later in the tax year and there is growing incentive to delay the sale for tax purposes.

To use an example, the investor purchased shares of XYZ Financial at $20.00 a share. Over the next 6 months the stock proceeds to rally to $40.00 into November of that year. This price move exceeded analyst targets and the valuations are becoming expensive from a historical perspective. Instinctively, the investor is inclined to want to just sell the shares, but would incur the tax disposition in the current calendar year.

Alternatively, the investor could simply hold into the New Year to defer the tax disposition, but risks that the stock could considerably reverse and the investor would miss the window of opportunity to have sold.

So how would an investor build an options strategy to defer the sale into the next tax year, but at the same time secure the price at these higher levels? Using the collar, it would involve the buying of a multi-month protective put, in this example the investor picks the January $38.00 put for $0.35 or $35.00 for every 100 shares. The second leg of the strategy involves selling a covered call for a premium income. In this example, the investor picks the January $42.00 call, which is bidding $0.22 or $22.00 for every 100 shares. What the investor has created is a hedge wrap with little to almost no significant cost ($0.13 net). At the same time, the investor can now comfortably wait the several months to sell the shares in the new tax year. The collar has secured a worst case scenario sale at $38.00 and a best case scenario of a sell at $42.00.

The consideration for investors is that most call options are American style, which means in theory the $42.00 covered call can be exercised before the new calendar year. While always a risk, it can be considerably diminished by simply observing the x-dividend day and if the call option is in-the-money prior to the dividend payment. In that circumstance, the investor can close or roll the covered call to another strike to manage that risk.

If you are investment advisor or portfolio manager in the Vancouver area and would like to learn more, the Options Conference is on April 3^rd at the Fairmont Pacific Rim. Use this link to learn more.