As part of year-end tax planning, it is common to review a client’s investment portfolio. If there are capital gains (and yes, this year there are), we go looking for capital losses to offset those gains. What is the point of sitting on capital losses when the alternative is to send Uncle Sam a check for taxes on capital gains? This process is called “loss harvesting,” which term I find to be both humorous and macabre.
Let’s go the other way. What if the client has capital gains but is concerned that the gains may evaporate. Sell the stock, we would say. No, says the client; the stock is a winner. The client however is concerned about market swings before getting to the long-term. What if he or she needs the money and the swing is down? Given market behavior since 2007, this is not an unreasonable fear. What if he/she is just wrong about the stock?
There are a few things you can consider to protect that gain. Today I want to talk about one. We will come back and talk about other techniques, but let’s do it another day.
The technique today uses protective puts. Yep, we are talking options.
You may remember that there are two basic types of options: calls and puts. If a sell a call to you, you have the right to buy my stock. If I sell a put to you, you have the right to sell me your stock. The direction I want here is to buy a put. That means I can require you to buy stock that I own. Since I am buying, this is going to cost me money.
An example is the way to go.
P&G closed today at around $62. Let’s say I believe that P&G is a good long-term hold (which I do, by the way), but I want to hedge my bets. I bought P&G at a great price, say $42. Nice unrealized gains here. Let’s say I have been reading articles by Nouriel Roubini and am terrified of imminent economic collapse. What if P&G goes to $20 before it goes to $100?
I will buy a $60 put for January 2012. That means that – until January, 2012 – I can require you to buy my P&G at $60 a share. You are not going to do this from the goodness of your heart. I am going to pay you approximately $5 for the right. This $5, by the way, is called the “premium.” You can look it up on stock market websites. You do not believe that P&G is going to crash. You believe that it will trade within a range or maybe even go up. You know that I would never sell you the stock if it stays above $60. Even if I do, I paid you $5, so your net cost is $55 ($60 - $5) for the stock.
If the stock goes up or moves sideways, I will likely allow the put to expire. I am not going to sell you stock at $60 when I can call Fidelity and sell at a higher price. I wasted $5 on the premium.
Say the stock goes to $40. Different answer. I exercise the put and require you to buy the stock. I sell at $60. I paid $5. I cleared $55, and I can turn around and buy the stock at $40. There is no wash sale, because I sold at a profit. The wash only applies when one sells at a loss.
There is a non-intuitive tax result in here, by the way. Let’s say that I let the put expire. My first response is that I have a $5 capital loss, which is the premium I paid for the put. I am partially right. I do have a $5 loss, but the IRS will not let me deduct it. Since I still own the stock, the IRS requires me to increase my basis in P&G by that $5. I will get it back someday – when I sell the stock. The technical reason is that the protective put creates a tax “straddle,” and the result I described is the general result for tax straddles.
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