equityderivative strategies equity derivative strategies · 2018. 11. 16. · straddles. the first...

Equity Derivative Strategies

Equity Derivative StrategiesJoanne M. HillVice President, Equity DerivativesGoldman, Sachs & Company

Understanding the tax implications of equity derivatives and the application of theseinstruments for taxable U.S. clients is a challenge worth meeting. Equity derivatives canplaya useful role in implementing tax-efficient strategies that maximize after-tax returns.The key is to understand the costs, benefits, and rules for applying each instrument orstrategy and then to select the best instrument to accomplish the investor's objectivesand minimize the taxes.

H istorically,u.s. trust departments that managedmoney for taxable investors were restricted in

their use of derivative securities. Because of suchobstacles (some of which are a matter of educationmore than anything else), derivatives are not the firsttool that comes to mind for managing taxable investments, even though they offer advantages for manyclients. Derivatives are often perceived as complex inthemselves; the roles derivatives can play when taxesare involved add yet another layer of complexity.Equity derivatives, independent of any tax motivation, are used for reducing the risk of holding equitiesor as efficient substitutes for equities. In both contexts,derivatives have natural applications in tax-relatedstrategies. This presentation discusses the general taxissues facing corporate money managers or high-networth individuals with respect to equity derivatives,explains how to use derivatives to maximize after-taxportfolio returns, discusses specific tax-efficientderivative strategies, and provides a case study highlighting tax loss harvesting.'

General Tax IssuesBefore a discussion of applications of derivatives forenhancing after-tax returns and risk management, areview of the general U.S.tax issues that affect the useof equity derivatives will be helpful. The most common issues are how to distinguish between long-termand short-term capital gains and the dividendreceived exclusion. More-complex issues involvestraddles, stock option transactions, qualified coveredcalls, Section 1256contracts, and the wash-sale rule.

1I would like to acknowledge the contributions of Michael Dweck,Carmen Greco, Maria Tsu, and Mark A. Zurack in conducting theresearch and compiling the insights for this presentation.

©Association for Investment Management and Research

Capital Gains. For individuals, sales of securities generally result in a long-term capital gain or lossif the securities are owned more than 12 months. Aholding period of 12 months or less results in a shortterm capital gain or loss. For individuals, net longterm capital gains are taxed up to a federal rate of 20percent whereas net short-term capital gains (andordinary income) are generally taxed at the top marginal tax rate of 39.6 percent.

Dividend Received Exclusion. us. corporations that hold equity in other u.s. corporations mayexclude 70 percent of dividend income from theirincome tax. One requirement is that the position beheld"at risk" for 46 days. The impact of this dividendexclusion is that corporations generally have anincentive to convert as much income into qualifieddividends as possible. In this regard, common andpreferred stock are preferable to fixed-income securities.

Straddles. The first question to answer whendiscussing the tax status of a derivative transactionis whether it constitutes a straddle. If a security or aderivative substantially diminishes the risk of loss ofanother security, this set of securities is considered astraddle position. Straddles include hedging a stockwith a swap, a long put, or a short "nonqualified"call (qualified versus nonqualified calls are definedin the section "Qualified Covered Calls"). Sellingstock index futures or stock index call options orbuying index puts against a portfolio that holds morethan 70 percent of the market capitalization of theindex constitutes a straddle because it basically takesan indexlike portfolio and hedges it.

69

Investment Counselingfor Private Clients

Straddle situations affect taxable investors inseveral ways. First, the investor's holding period iseither suspended or terminated, which is not necessarily abad thing if the investor already has long-termcapital gains. Second, and most troublesome, is theinability to deduct losses to the extent that the investor has an unrecognized gain. Also, financing chargesfor straddle positions are not deductible. Instead, forthe investor in a straddle situation, the charges arecapitalized into the cost basis of the long position.Finally, corporations lose the 70percent deduction onall qualified dividends for stocks that are part ofstraddle positions. Only in a few circumstanceswould a company want to do something that wouldconstitute a straddle; corporations should generallyavoid straddles.

Stock Option Transactions. The premium received or paid for stock option transactions is considered a capital item. When a physically settled stockoption is exercised or unassigned, the cost basis orsale price can be adjusted by the premium receivedor paid. Stock options, with the exception of listedindex options, are generally not marked to market atyear end for tax purposes. The tax treatment of stockoptions depends on the time to expiration, the typeof option, and how it is exercised or assigned.

Short-dated options. Profits on short-datedoptions are generally considered short-term capitalgains, but losses may be considered long term if theoption is part of a straddle position.

Long-dated options. For buyers of long-datedoptions, the tax treatment depends on the holdingperiod. For example, if an investor buys a LEAP(Long-term Equity AnticiPation security-that is, anoption that has 18 months, two years, three years, ormore to expiration) and holds it to term, the gain onthat option will qualify as a long-term gain.

Call exercise/assignment. The cost basis or thesale price (i.e., the strike price) is increased by theamount of premium paid or received. For example,ifan investor is short a call and sells the stock throughthe exercise of the call, the premium is reflected in theselling price of the stock.

Put exercise/assignment. Similarly, the costbasis or sale price of stock is decreased by the amountof the premium paid or received from a put.

Cash settlement. For cash-settled options, suchas index options and some GTC options that are neverassigned or exercised, the premium paid or receiveddoes not become part of the cost basis. Options thatare never assigned are treated like a physically settledoption that is closed out prior to expiration.

Qualified Covered Calls. Covered call optionsmust meet several criteria to be considered qualifiedcovered calls. First, they must be listed and exchange

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traded. Second, they must have more than 30 days toexpiration. Third, the strike price must be not lessthan the first available strike price below the closingstock price. For example, if the stock closes at $52, anoption with a strike price of $50 is the first call onecould sell for it to be considered qualified.

Qualified covered calls can be used to extend theholdingperiod, and they are probably the most widelyused instrument for deferring gains. Selling a qualifiedcovered call against a stock results in a capital gain orloss to the call writer, allows the holding period tocontinue if the call is out of the money, and suspendsthe holding period if the call is in the money. In theexample of selling the call with the $50strike price, theholding period is suspended. Finally, covered callsalso allow for the dividend received exclusion.

Section 1256 Contracts. These contracts include U.S. exchange-traded stock index futures,broad-based index options, and options on indexfutures, which are all accorded the same tax status ascommodity futures. Examples of Section 1256 contracts are S&P 500 Index futures and options, CME(Chicago Mercantile Exchange)-Nikkei futures contracts, and SIMEX-Nikkei futures contracts. Thegood news is that no matter how long an investorholds these derivatives, any gain or loss on Section1256 contracts is treated at 60 percent long term and40 percent short term. Section 1256contracts provideinvestors the ability to sell short and obtain partiallong-term capital gains tax treatment and to make theholding period irrelevant for long-term and shortterm capital gains tax treatment. The bad news is thatthese derivatives are marked to market every year;therefore, a tax event occurs every year if these positions remain open at year-end. In addition, investorsare unable to qualify for 100percent long-term capitalgains tax treatment.

GTC index options are not considered Section1256 contracts and are treated the same as singlestock options for tax purposes. Therefore, if structured with a term greater than a year and held for ayear or more, gains on a long GTC option can betreated as long term. Also, taxes are payable following the year the option is sold rather than marked tomarket annually as with 1256 contracts.

Wash-Sale Rule. Call options cannot be used toavoid IRS Section 1091, the wash-sale rule, whichprevents taxpayers from selling securities at a lossand reacquiring "substantially identical" securitieswithin a 30-day period before or after the loss sale.However, although an investor cannot sell a stockand replace it with a call option, the investor can sella stock and replace it with a short put under certainrestrictions.


A short put represents the right to sell a stock ata fixed price to the writer. If I sell a put, somebodyhas the right to sell the stock to me at a fixed price.The put arrangement is good news if I have a positionwith a loss in it and I want to harvest it in order tooffset a capital gain. When I sen the underlying stock,I realize my loss, and when I short a put, I givesomeone the right to sen that stock back to me at afixed price. If the other investor exercises the putoption that I sold and sells the stock back to me, myoriginal stock position will be reestablished.

Investors should keep in mind that selling a putdoes not violate the wash-sale rule as long as the putoption is not deep in the money. Thus, to harvestlosses and not be subject to the wash-sale rule, aninvestor can sell a put and keep the cash in a moneymarket account for the 31 days. This approach is auseful way of harvesting losses.

The premium from the short put can also offsetsome of the potential opportunity losses if the stockturns around and rides all the way back up. To theextent that the investor believes volatilities are trading well above their historical levels, he or she is, infact, making a strategic volatility sale on the optionpremium and will have that protection toward theupside of the stock. On the 32nd day, when the optionexpires, the investor can take the money out of fixedincome instruments and buy the stock again.

Strategies to Maximize After-TaxReturnsIn portfolio management, derivatives are simply oneway to maximize after-tax returns for individualinvestors. Many derivative applications require measurement of asset-class or country risk. Examples areoption strategies, structured asset allocation strategies, and risk management. Using derivatives, portfolio managers can efficiently manage portfoliocharacteristics in terms of turnover and dividendyield, make asset allocation shifts, and achieve synthetic index exposure.

General Portfollo Characteristics. Derivatives can be used to alter the general characteristicsof a portfolio-for example, to tilt a taxable investor'sportfolio toward low-yield stocks that earn more oftheir returns from capital than from dividendincome. Call options provide economic exposure toa certain stock without earning the dividend yield bypaying at expiration the difference between the stockprice and the option strike price. If an investor takesa stock that has a high dividend yield, such as apharmaceutical stock or an oil stock, and replaces itwith a LEAP or a long-term call option on the stock,



the investor can maximize the long-term capital gainscomponent of total return. In addition, the LEAP, likestock, allows the portfolio to be hedged with indexfutures or options without creating a straddle position. If the investor holds that position for more thana year, the investor has a long-term capital gain andhas received no dividend yield. Depending on whatthe investor is doing with the money that is not beingused to buy the underlying stock, the investor could,if desired, use options to slightly leverage the position in the stock.

Asset Allocation Shifts. Index derivatives canbe used to manage asset-class or country allocations.The benefits are that the investor gets the 60/40 capital gains treatment and minimizes transaction costs,including taxes, commissions, the bid-offer spread,and market impact. For example, consider a portfoliomanager for a taxable investor who is concernedabout the risk of the stock market but does not wantto sell stocks because of the taxable gains associatedwith a sale. To reduce the risk of triggering a taxablesale of stock, the manager can sell index futures or buyan index put option to hedge the portfolio. Instead ofselling the investor's large-eapitalization U.S. stocks,the manager can sell an appropriate amount of S&P500 futures contracts against those stocks to reducethe portfolio's equity exposure, or if the managerwants to shift assets from one country to another, themanager can use futures contracts. But the managerhas to be careful that the underlying portfolio does notrepresent more than 70 percent of the capitalizationof the index; otherwise, both securities are consideredpart of a straddle position. Generally, in addition tohaving a low trading cost per se, futures also have thisdesirable tax treatment.

Creating Index Exposure. If an investor wantsto achieve exposure to a certain index, the investorcan choose between index funds, separate accounts,S&P 500 Depositary Receipts (SPDRs), and futures.The choice will depend on the investor's specificneeds. Exhibit 1 provides a comparison of these waysto gain exposure to the S&P 500.

Mutual funds. Index exposure through amutual fund makes tax loss harvesting difficultbecause investors' funds are commingled and theinvestor might have a capital gains distribution.

Separate accounts. Separate accounts makesense for investors who value tax loss harvestingbecause an account can be customized to fit the investor's needs. Separate accounts also provide the flexibility of reducing turnover by avoiding frequentrebalancing, although infrequent rebalancing resultsin tracking error. Turnover tends to run 2-5 percenta year for most index funds and up to 20 percent for

71


Figure 1. SPDR Market Size and Volume

9

8

1/ 7

6 ~§,.Q

5 ~Qj

m4 "0

§~...

3en

tE2

1

Trading Volume(left axis)

Fund Size(right axis)

"'~ 12..c:en.....0

.~ 10;::I

!Qj 8~'3be

6.S"0III

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4.;;;.Jill-0 ... ..

g},III....Qj 2~

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14r---------------------------,

1/97 3/97 5/97 7/97 9/97 11/97 1/98 3/98 5/98 7/98 9/98

When an investor buys the underlying stocks inan index, the investor receives the dividends, thecapital gains or losses (depending on the endingvalue of the index), and the return on stock lending.Stock index futures and equity swaps offer means ofgenerating index returns that are both flexible andefficient.

Buying stock index futures and investing infixed-income securities provides interest incomefrom the fixed-income investments and capital gainsor losses minus the futures premium. The futurespremium equals the futures price minus the currentindex value, which is the same as the index valuemultiplied by the interest rate, minus the dividendyield on the index minus the return on stock lending.

Futures allow an investor to capture some longterm capital gain-60 percent long term and 40 percent short term-on trading profits, but one drawback with futures is that creating the economicequivalent of an S&P500index fund involves buyingan S&P500 (or a Russell index) futures contract alongwith a money market fund investment of the samematerial value. The money market fund may generate interest income that is taxable, but taxable investors can avoid the taxes by using a money marketfund that has some tax relief from, if not federal, atleast state, taxes-for example, by investing in amunicipal bond money market fund. Because themoney market fund pays interest income, the taxablepayoff from combining the futures contract with themoney market fund may be higher than the dividend

yield on an index, so this strategy is not necessarily aperfect substitute for an index fund.

Entering into an equity swap and investing infixed-income securities is similar to investing infutures contracts. Investors earn interest income fromthe fixed-income investments, the total return on thespecified index (gains plus dividends), less a fixedrate or floating-rate payment made to the swap counterparty. An investor will generally be indifferentbetween buying the underlying stocks in an indexand entering into a swap when the interest incomefrom the fixed-income investment equals the sum ofthe fixed- or floating-rate payment plus the return onstock lending.

Synthetic index strategies provide investors withseveral benefits compared with buying the underlying stocks in the index. These strategies provideinvestors flexibility, operational ease, lowered transaction costs, opportunities for return enhancementthrough mispricing, and favorable tax consequences.

Synthetic strategies also have applicationsbeyond achieving index exposure. Investors can usethem to equitize cash positions and "transport alpha"to another asset class. An alpha-transport strategyenables a successful manager in one asset class, forexample, to transport that skill to another asset class.Synthetic strategies are also helpful during managertransitions, for implementing a global asset allocation strategy, and for creating enhanced index funds.

Tax-Efficient StrategiesOnce investors have a strong understanding of deriv-

©Association for Investment Management and Research 73

InvestmentCounseling for Private Clients

ative instruments and their applications, portfoliomanagers can use these instruments to implementtax-efficient strategies that accomplish their clients'objectives. Three common objectives of taxable investors are converting short-term gains into long-termgains, managing market risk, and reestablishingexposure to stocks sold at a loss. Implementing derivative strategies to meet these objectives may addressspecific issues and provide important benefits, but italso may create certain risks for the investor.

Converting short-Term Capital Gains. Agood strategy to minimize the recognition of shortterm and medium-term capital gains is to considerselling call options against the underlying stock position rather than selling the underlying stock andincurring capital gains. For example, suppose aninvestor is not as bullish now on a stock that hebought nine months ago and would like to reduce thesize of his position. The cost basis of the stock is $25,and it is currently trading at $50. The investor caneither sell the existing stock, buy a new stock andhave a short-term capital gain, or write a nine-monthcall option with a $52 strike price and receive a $6option premium.

The key is to sell a qualified call option-one thatis either at the money or out of the money. Assuminga long-term capital gains tax rate of 20 percent and ashort-term capital gains rate of 40 percent, if the investor sells the stock today, he will be left with $40 inafter-tax dollars. If the stock moves above $52, theinvestor will generate a $33 (that is, $52 + $6 - $25)long-term capital gain. The investor's gain on thestock is limited because he has sold the right to ownthe stock to someone else. If the stock trades below thestrike price, the option premium is taxed as a shortterm capital gain. If the hedge is established, the stockwill have to drop below $39.25 for the investor to beindifferent between the alternatives. Thus, as long asthe stock trades above $40, the investor is better offselling that option and deferring the gain. If the investor sells the call option at $6 and then sells the stock at$40, the investor's after-tax proceeds will be approximately $40 (60 percent of the $6 option premium, or$3.60, plus 80 percent of the $15 gain on the stock, or$12, plus the original $25 cost basis of the stock).

Investors often make the mistake of selling nonqualified calls. If a stock closes at $56 on one day andthe next day it opens down $2 and is trading at $54,some investors, believing they are not going to affecttheir holding period, may want to sell a call optionwith a $55 strike price, but the qualified call optionrule is generally based on the stock's previous night'sclosing price. Investors make this error especiallywhen stocks are having down days; they think theyare selling out-of-the-money calls when, in fact, they

74

are not. The options are out of the money at the time,but they are not out of the money based on the rulethey are supposed to be following. What the investorsend up doing is freezing that holding period.

Investors commit a greater error if they sell a calloption that is two strike prices in the money, becausenot only do they freeze the holding period while theoption is in place but they also reset the holdingperiod to zero days at the expiration of the option.

Managing Market Risk. Investors can managemarket risk and maintain long-term equity or bondholdings by using index futures and options onstocks, bonds, and indexes. For example, if an investor with substantial capital gains in many securitiesis concerned about the market and would like toreduce overall market exposure, she can sell stocks toincrease her cash holdings, but by doing so, she generates substantial taxable capital gains. Instead,hedging stocks in a taxable portfolio with large gainswith options or hedging the overall portfolio withstock index futures are good strategies for managingmarket risk and reducing tax consequences. The keyis to make sure the portfolio and the hedge positionsdo not create a straddle (unless she is comfortablefreezing her holding period). To avoid conflict withthe straddle rule, this investor may have to modifyher portfolio to make sure that it does not representmore than 70 percent of the market capitalization ofthe index. An alternative is for the investor to look fora combination of index options or index futures thatdoes not create a straddle. Index futures currentlytrade on a variety of indexes, including the Russell1000 or 2000, the DJIA, and the Nasdaq 100, so putting together a basket of index options or indexfutures that does not violate the straddle rule shouldnot be difficult. Investors also have to be mindful ofthe different tax treatments of listed and OTCoptions.

Tax Loss Harvesting. An investor may want tosell a stock at a capital loss to offset a realized gain inher or his portfolio. Once the stock is sold, however,it cannot be repurchased for 31 days (without triggering a wash sale), and the investor may be worriedabout being out of the equity market during a periodwhen the market is appreciating, missing out on atakeover opportunity, or missing out on a favorablemove on a particular stock during the 31-day period.Selling put options is an efficient way to reestablishexposure to such stocks sold at a loss.

If the investor is selling a diversified group ofstocks, one strategy is to sell the stocks at a loss andthen replace them with an index-based instrument,such as a futures contract or a SPDR, for 31 days. If theinvestor does not want to "double down," the inves-


tor can sell a put to reestablish some economic exposure to the stocks. The put sale offers two importantadvantages. First, as long as the put is not deep in themoney, it does not violate the wash-sale rule. Second,transaction costs are low because the put and stocksale tend to offset each other and if the put is exercised,the stock position is reestablished.

Consider an investor who owns a $50 stock thathas a capital loss. He sells the underlying stock andthen sells a put option on that stock with a strike priceof $55; assume he receives a $5.30 premium to reestablish exposure to that stock. As long as the stocktrades below $55, this investor will end up effectivelyrepurchasing the stock at $49.70 because the optionbuyer will be happy to exercise the right to sell thatstock at $55.

The downside of the strategy is that if the stockplummets to $30, the investor will have to pay $55forthe stock when the option buyer exercises the option,but if the investor had not sold the stock or the putoption, the stock would still be worth $30. The consequences on the downside are similar to being in thestock itself.

On the upside, if this stock appreciates significantly by expiration of the option-to $60, $65, oreven $70-the investor's put option will expire unexercised. Then, to reestablish the position, he will haveto buy that stock in the marketplace for whateverprice it is trading for at the end of the 31 days. Theinvestor receives the put premium, however, as somecompensation for having taken that risk. This strategy is clearly better than being altogether out of astock that appreciates significantly.

The structure and timing of such a transaction areillustrated in Figure 2. In this illustration, the broker/dealer is taking the other side of the trade, but theinvestor could also simply sell the put option in themarket. The investor has, say, 100,000shares and sells30,000 shares in the market and 70,000 shares to thebroker/dealer. The transaction implicitly assumessome delta hedging and that the broker/dealer isbuying the put option and some of the underlying


stock from the investor. By selling the stock to adealer, the investor gives the dealer a natural hedgefor the put option that the dealer bought from theinvestor. At the end of the transaction, the dealerexercises the put option and the investor can reestablish the stock position. The benefit to the investor ofcompleting this transaction with a broker/dealer isthat transaction costs are very low.

Case Study: Tax loss HarvestingTaxable clients need to select the stocks in their portfolios that are best suited for harvesting losses. Todecide among the several strategies available forselecting stocks for harvesting tax losses, the portfoliomanager needs to consider the client's objectives andother important issues. The investor may want toharvest tax losses efficiently to offset taxable gains onother assets or to rebalance the portfolio to improvecorrelation to a benchmark.

Important issues to consider before implementing a harvesting strategy include• determining the criteria for prioritizing the har

vesting process,• estimating the marginal tax benefit assigned to

any realized losses,• deciding which stocks to replace immediately

and which stocks to repurchase 31 days later,• assessing whether the extent of harvesting will

affect the degree of rebalancing needed toimprove the correlation to the benchmark, and

• choosing strategies to manage exposure duringthe 31-day period.Three strategies are available for prioritizing the

tax-lass-harvesting process. Some of my colleagues,Mark Zurack and Maria Tsu, have recently conducted a detailed analysis for a taxable client of therelative merits of these strategies. The strategies yieldsimilar results if almost all of the losses are realized(i.e., if greater than 95 percent of the losses are harvested) but differ in efficiency if the client wants torealize a smaller portion of the losses.

Figure 2. Structure of Put Option Transaction to Reestablish ExposureInitially. . . 45 Days Later ...

Sells 70,000Shares

~~ Broker/~~ Dealer

Sells 30,000 Sells PutsShares

Market


Stock < $55,

e Exercises Put

~ Broker/Investor Dealer

~ --------Stock> $55,t Receives StockBuys Stock

G75

Investment Counseling for Private Clients

"Marginal benefit exceeds marginal cost of transacting.

Table 1. Percentage of Stocks with LossesHarvested

loss-harvesting strategy.

Managing Exposure during the 31-DayPeriod. At least three approaches exist to mitigatethe exposure during the 31-day waiting periodneeded to avoid a wash sale: holding cash, buyingSPDRs, and selling a put option on the stocks to berepurchased in 31 days. Each strategy has distinctadvantages and disadvantages.

Holding cash. This approach is quite simplefor investors; it involves no transaction costs and noloss of principal if the market declines. But investorswill experience a drag on performance if the marketrebounds. Holding cash will also earn investors lessthan selling put options.

BuyingSPDRs.This method reduces trackingrisk relative to a benchmark and provides market

Strategy 1 is to harvest stocks if the marginal benefitexceeds the marginal cost of transacting. Strategy 1 isapplicable if the marginal tax benefit for realizedlosses is 25 percent of the realized loss and the marginal cost is 1percent of the notional value of the stocksold (including round-trip commission costs and themarket impact of trading).

Strategy 2 involves minimizing transaction costsversus the value of losses realized by harvestingstocks with the largest percentage loss first until thedesired amount of losses is harvested or a target levelof turnover is reached. This strategy can applywhether or not the investor uses put options.

Strategy 3 involves harvesting stocks with thelargest dollar loss first until the desired amount of lossesis harvested or a target level of turnover is reached.

Strategy 3 is less efficient than Strategies 1 or 2.As the comparison in Table 1 shows, if 95 percent orless of the available losses are harvested, Strategy 2provides the most efficient means of harvesting. InStrategy 2, an investor can harvest 85 percent of thelosses by selling 53 percent of the value of stocks withlosses. Thus, the investor will realize the highestpercentage of losses among the smallest percentageof stocks. Figure 3 shows the relationship betweenthe percentage of realized losses and the percentageof stocks with harvested losses for the three strategies. Unless the percentage of available lossesexceeds 95 percent, Strategy 2 remains the best tax-

Percent ofLosses

8085909599

Strategy 1(MB> MC)a

57.7

63.1

67.573.9

87.3

Strategy 2(by % loss)

46.9

52.960.370.687.2

Strategy 3(by $ loss)

64.2

70.075.480.990.5

Figure 3. Performance of Strategies for Harvesting Tax Losses

110~-----------------------------,

100

80

.'Strategy 1

/,Strategy 3

20 ..

10080604020ow:.... -' ~J. .

o

Percent of Stocks with Losses Harvested

Note: Indicative pricing as of October 7, 1998.

76 ©Association for Investment Management and Research

exposure if the market rebounds. Drawbacks includethe transaction costs to buy and sell SPDR shares andthe condition that buying SPDRs provides no offsetto stock-repurchase costs.

Selling puts. An investor who follows thisapproach will obtain an up-front option premium,which lowers the investor's cost basis. Transferringstock to a dealer (as shown in Figure 2) reduces themarket impact of selling stock. Complexity and performance lags if the market rises rapidly are majordisadvantages of selling puts. In addition, the effective purchase price of reestablishing stock exposuremay be above the current market price if the marketdeclines sharply.

Figure 4 demonstrates the payoff from sellingputs for a client who wants to sell a put option on a$50 million basket of 300 stocks with a dividend yieldof 1.95 percent to be repurchased in 31 days. If thestock falls significantly during the 31-day blackoutperiod, the investor is better off simply liquidatingthe position. With the current basket price at $100, theclient sells a putwith a $107strike price for a premiumof $8. Table 2 indicates that as long as the basketremains below $107, the effective cost of reestablishing the basket of stocks is $99. At prices above $107,the put option expires worthless but the initial premium helps offset the cost to repurchase the stocks.


Table 2. Example Strategy of Selling Puts

BasketPrice Put Value Purchase Price Effective Price

$ 92 $15 $107 $ 9993 14 107 9994 13 107 9995 12 107 9996 11 107 9997 10 107 9998 9 107 9999 8 107 99

100 7 107 99101 6 107 99102 5 107 99103 4 107 99104 3 107 99105 2 107 99106 1 107 99107 0 107 99108 0 108 100109 0 109 101110 0 110 102

Note: Indicative pricing as of October 7,1998.

ConclusionEquity derivatives are useful instruments for maximizing the after-tax returns of a taxable investor's

Figure 4. Payoff from Seiling Puts115

110 Purchase Price ifPut Not Sold-,

tEffective Priceif Put Sold

90

11211010810610410210098969485 L-_---l.__--L..._-.J__~__..l...__ _..l..___'__ __'___'___ __'

92

Market Price of Basket ($)

©Association for Investment Management and Research n

InvestmentCounseling for PrivateClients

portfolio because they offer alternatives to highdividend stocks, provide a way to implement assetallocation shifts, or allow the creation of syntheticindex exposure. Equity derivative strategies can alsobe used to efficiently convert short-term capital gainsinto long-term capital gains, reduce the implementation risk as a tax-lass-harvesting strategy byhelping investors manage market risk during the 31day lock-up period associated with avoiding washsales, and maximize the benefits of tax loss harvesting.

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Investors and portfolio managers need to understand the general tax issues surrounding equityderivatives before considering using them. Important considerations are the rules involving straddles,qualified covered calls, and wash sales. Also vital toeffective use of equity derivatives is an understanding of what each instrument or strategy can andcannot do; the benefits, risks, and costs of each strategy; and most importantly, the tax implications ofalternative strategies.



Question and Answer SessionJoanne M. HillCarmen Greco2

Question: Are SPDRs considered Section 1256 contracts?

Hill: No. Section 1256 contractsinclude futures or options thattrade on a listed exchange. Section1256 contracts were initially created to apply to commodities futurescontracts. When index optionsstarted trading on the ChicagoBoard Options Exchange, theCBOE wanted to make themcomparable in terms of tax treatment to futures index options thattrade on the Chicago MercantileExchange. Initially, the Section1256 contracts were brought in toinclude index options, but for taxpurposes, SPDRs are treated likethe purchase or sale of a stock. Theprimary disadvantage of SPDRs isthat you pay a commission topurchase one, but if you hold theposition a long time, the commission is amortized over a longperiod of time.

When an investor buys aSPDR,the investor does not receiveexactly the same return as the S&P500. For example, if you mark theSPDR at the end of a month andcalculate the tracking error of thatSPDR position to the S&P SODreturn, the error will be 1O()-.140basis points. In other words, a portfolio performance report at the endof any month for SPDR positionswill not be marked where the S&P500 closes that month but wherethe SPDR closes that month. If youaccumulate enough SPDR shares,the shares can be converted intounits of the trust and you can actually take physical delivery of the

2Carmen Greco, who works with Ms. Hill inthe area of equity derivative strategies atGoldman Sachs, joined Ms. Hill for thisquestion and answer session.

trust holdings. Large institutionsoften arbitrage SPDRs by accumulating a number of units and converting them.

You have to take tracking riskto hedge the market risk of a portfolio that isn't a perfect replica ofthe benchmark index. So, SPDRsprovide the tax advantage but takeaway the tracking benefit.

SPDRs trade at different pricesfrom the index because they trackfutures, in the following sense: Ifthe market goes down sharply onthe last day of the month, futureswill go out cheap and end up selling below where they should.Why? Because traders are in themarket hedging since they cannoteasily short a stock portfolio. Thereis a plus tick rule, but investors cansell futures, so futures are tradingcheap. The market maker of theSPDRs, who is a specialist on thefloor of the exchange, will nowadjust the SPDR price based onwhere the market maker canhedgehis or her position in the futuresmarket. So, the market maker ismaking a market based on thehedging instrument, which is thefutures contract. SPDRs will go outa little bit below the index on a bigdown day or above the index on abig up day. On a big up day, everybody comes in and buys SPDRsbecause they want to capture thatmove. So, a potential marking riskis present at the end of a, say, quarterly performance period thatintroduces some tracking error.That error washes out, however,over an annual period.

Greco: An advantage of SPDRsis that you don't need a plus tickto sell them short. So, when managers are not allowed to usederivative products, many of

them use SPDRs for hedgingbecause they don't want any extrapaperwork and their chartersallow the use of SPDRs. They senSPDRs short for asset allocationand hedging purposes.

Question: Is shorting a SPDRagainst a diversified portfolioconsidered a straddle?

Hill: If that portfolio containsmore than 70 percent of the marketcap of the S&P 500, then shortingthe SPDR constitutes a straddle.The 70 percent rule also applies ifyou go on the other side-long aSPDR and short a diversifiedportfolio.

Question: In selling call optionsto convert short-term capital gainsto long-term term capital gains, ifyou write a $52-strike call and thestock immediately goes throughthe strike price, are the capitalgains on the stock still long term?

Hill: Going through the strikeprice has no effect as long as theoption holder does not exercise theoption. But if the option gets deepenough in the money that someoneexercises it prior to expiration (12months), then the other side will beforced to sell the stock. Exercisingan option early is irrational (it'snever optimal to exercise options earlyfrom an option-pricingstandpoint),but such things do happen, especially before a dividend payment.

Greco: A physically settled option entails no tax on the option.Options take on the holdingperiod characteristics of the stockposition, so if you enter into aphysically settled option, youactually deliver your stock. If the


Investment Counselingjor Private Clients

stock is held for 12 months and aday, it will trigger a long-termcapital gain that is equal to the exitstrike price plus a premium. Forexample, if you sell the $50-strikecall for $5 and you have a zero costbasis, you're facing a $55long-termcapital gain, but you can convertlong-term gains to short-termgains if you settle the option forcash. To remain flexible, however,you need to be leery of physicalsettlement. A customized optionallows you to stay flexible as longas you don't have restricted stock.

Question: Hedging with putoptions and short calls (collars) tominimize concentration risk requires liquidity in the security.What other strategies are feasiblefor relatively illiquid securities?

Greco: Stock borrowing and liquidity are the first things we lookat in terms of engaging in a strategybecause we do not take a directional view on the stock. We hedge ourpositions, and that practice ispretty consistent throughout theinvestment community. If someone can't borrow the stock and theunderlying stock has no liquidity,people who take on a counterpartyposition will not be able tomaintain an economically neutralposition throughout the life of thetrade, so they will not engage in thetrade in the first place.

Question: What are some of therisks that one should be wary of inentering into these kinds of contracts?

Hill: First, there is documentation risk. You should make surethat your client is educated aboutall the features of these derivativesand that your investment advisoryagreement dearly authorizes youto engage in options and/orfutures transactions. It is one thingif the market falls 50 percent andthe client owns a stock portfolio

and is not happy. There is notmuch the client can do about it. Butif a client has a loss on a derivativecontract, the client will probablylook for ways to get out of realizingthat loss. And the client might saythat you were not authorized totrade derivatives.

Marked-to-market risk tips thescales in favor of trading listed orexchange-traded instruments.Listed markets broadly disseminate closing prices, of course. Thepossibility always exists that theoption market will be disrupted inan emergency situation, but recentrevisions in the circuit breakersreduce the likelihood that a closingprice cannot be established at theend of each trading day.

Growth in stockoption volumehas been 2(}-30 percent in the pastthree years. Stock options are regularly used as part of corporate buyback programs, hedging singlestock risk, and covered call writing.A good balance exists between buyers and sellers in single-stockoptions, so options don't containmuch hidden risk-s-as long as youare using options in an unleveragedway. Some kind of leverage test isalways a good idea, which does notmean that you should never useleverage. If you are using leverage,however, you have to make sureyou are authorized to do so and arenotdoing it surreptitiously througha derivative.

Question: What approach torecognize which strategies arelegitimate would you suggest forinvestment advisors who are notwell practiced in the use of optionsand derivatives?

Hill: First, try to involve a broadgroup of people in the organization, induding operations, legal,and custody staff. Not everyoneneeds to know all the nuances ofderivatives, but you should identify at least two people in each areaof the organization to become

knowledgeable about derivativesand then have them go to brokers,exchanges, industry educationalorganizations, or experts for education. AIMR, the Futures IndustryInstitute, and the Options IndustryInstitute regularly run educationalprograms on derivative strategies.Second, one or two in-house staffon the trading desk and inresearch-should specialize inequity or fixed-income derivativesto be a resource to the portfoliomanagers in helping them withstrategies. Another area where youneed a derivatives expert is in therisk management group. Start-upcosts are involved, but you needpeople in your organization whospend at least 50 percent of theirtime on risk management.

Greco: One of the best books onoptions is the reference bookOptions asa Strategic Investment.3 Itis long on strategies and short onmath, and it does a good job ofexplaining how strategies work,how to implement them, how toget out of them when things gowrong, and (because it is writtenfor the high-net-worth individual)how to optimize returns from a taxstandpoint.

Question: Are investment advisory firms or trust companiesusing derivative strategies to control fee revenue?

Hill: Yes, somewhat, but thepractice is not widespread. Wehave received a number of inquiries about hedging fee income, butfewer than 10 percent of institutions use derivative strategies tocontrol fee revenue.

The logic of such hedging isdear: The fees that many investment management organizations

3Lawrence G. McMillan, Optionsas a StrategicInvestment: A Comparative Analysis ofListedOptionsStrategies, 3rd ed. (New York:New York Institute of Finance, 1993).

80 ©Association for Investment Management and Research

earn are based on the portfoliosthey manage. Their fees are sensitive to the gains and losses on equities (and on fixed-incomeinstruments, to some extent, if theyare fixed-income managers). Andif a firm has sensitivity to theequity market, it can hedge the riskwith an index option.

The reason for not using derivative strategies to hedge fee incomeis that shareholders are buying the

stock of public securities management firms precisely for their sensitivity to certain markets. Forexample, investors buy T. RowePrice because it is an equity-relatedfirm. If you hedge away the marketsensitivity, you change the nature ofthe firm and investors are no longerbuying an equity-related firm.

The transactions that we'vedone tend to be for financial institutions that are subsidiaries of

EquityDerivative Strategies

larger entities, publidy tradedentities, or non-publicly-tradedentities with budget goals. Most ofthe cases we have been involved inhave been situations in which afirm is midway through the year, iswen in excess of its budgeted feeincome, and is wining to pay a littleamount of the excess of the fee budget or target to make sure thosegains will be realized or to holdthose gains through the year.


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