It is never too soon to think about year-end tax issues. Imagine that you have the opportunity to take a loss on a stock you own, but, since you like the prospects of that stock over the long term, you could still control the stock.

Have you ever bought a stock and it went down in value? While this is not an investment objective one would strive for, we have all been there at one time or another. With a stock that has gone down in price you have several options:

  1. Sell the stock, take a loss, and move on with the rest of your life. Your market outlook is no longer bullish, you are uncomfortable with the position, and the prospect of owning this dog stock is not too appealing.

  2. Buy more stock. You’ll never learn. Double up to catch up. You’re recalculated break-even point has been lowered, but the amount at risk has been increased dramatically. You may get more than one opportunity to try this with the same stock, increasing your risk every time.

  3. Do nothing, hope the stock rallies, say a prayer, light a candle, make a wish, etc. Doing nothing is actually doing something. It is saying you think a rally in the stock is certainly a possibility. You don’t like it enough to buy more and increase the risk substantially, but you are confident in your outlook.

How can one take a tax loss on the higher cost shares of XYZ stock and still control the stock?

There are very specific tax rules concerning what you can and cannot do before a tax loss can be established. (The accounting firm of Ernst & Young LLP has written a pamphlet entitled “Taxes and Investing for the Individual Investor”. An online version of this publication is available at www.888options.com and on the web-sites of the various option exchanges. Its treatment of the tax implications of various option strategies is much more complete than that given here, and can reflect recent changes). You should also consult a tax professional to discuss your specific situation.

If we were to try to summarize the current rule, the key phrase would be “30 days”. If you decide to sell a stock and establish a tax loss, you may not buy that stock or the equivalent position within 30 days of selling the stock. Those 30 days are both 30 days before and 30 days after the stock is sold. There are three ways:

  1. Sell 100 shares of XYZ at $50 on December 29. Wait 30 days. On January 29 buy 100 shares of XYZ. Where’s the problem? You have no position in XYZ for 30 days. Good earnings, the “January Effect”, a major product announcement, it doesn’t matter. If you buy the stock back within 30 days of the date of the sale you may not take the original sale as a tax loss.

  2. Buy 100 shares of XYZ on November 28, wait 31 days until December 29 and then sell 100 shares of XYZ. The problem? You already own 100 shares that you purchased earlier at a higher price. It didn’t work. The stock has dropped to $50 per share. You are buying 100 more shares and risking an additional $5,000 for the next 30 days. Even if you buy the second 100 shares on margin you still have $5,000 at risk.

  3. Tell us the LEAPS year-end strategy you like already...

  4. On November 28 (THANKSGIVING), buy (1) of the XYZ 13 ½ month LEAPS 40 strike price call at 15 points, or $1,500. On December 29 (CHRISTMAS) sell your 100 shares of XYZ and take the tax loss. On January 29 (SUPER BOWL), with 11 ½ months remaining until the LEAPS call expires, revisit the original idea. If stock ownership is the desired position, buy 100 shares and sell the long LEAPS call. If owning of the LEAPS call option is thought to be better, do nothing. The advantage of buying a LEAPS call 30 days before the date of the stock sale is:

  • You are in the market. You are not selling to establish the loss and then waiting 30 days to reinitiate the long position.

  • You control an additional 100 shares, but your additional risk is limited to the cost of the LEAPS call - $1500 in our example, versus the cost of an additional 100 shares, or $5,000.

  • The LEAPS call, with 13 ½ months of life, will not experience a great deal of time decay in the next 60 days (getting you 30 days past the stock sale on December 29). The Options Investigator software shows that if XYZ is unchanged, the LEAPS call will have decayed about $0.60 in the 60 days you held the position.

  • In-the-money call options have fairly large deltas. The delta of the 40 call with XYZ at $50 is 0.80. If XYZ goes to $60 on January 29 (with 355 days left until expiration), there are a few interesting items to look at. The delta at $60 with 11 ½ month left is almost 0.91. The option you bought at $15 should now be theoretically worth $23.05. You got your tax write-off, you controlled XYZ for a fraction of its cost (roughly 30% of the stock cost), you participated in over 80% of the stock rise to $60 and if you stick with the long LEAP call the delta is over 0.90.

The tax laws, while complicated and getting even more complicated as they relate to securities, are very specific in regards to the “30 days before and after” rule. Although one could try something similar with shorter-term options or at-the-money calls, the problem could be fighting the effects of time decay. As you know, with a 13 ½ month LEAPS call, the time decay on a deep in-the-money call moves at a glacial pace.

If the stock you own does not have LEAPS but you like this strategy, look at the longest-dated in-the-money call available (maybe a June or July). Use a software program like The Options Investigator and test-drive the position, weighing the risks and potential rewards.

The following are two examples of strategies that are not allowed:

  • You sell 100 shares of XYZ at $50 on December 29th, establishing a tax loss. On the following January 20, as XYZ announces good news, you buy (1) XYZ March 50 call option. The 100 shares of XYZ sold on December 29 cannot be used as a tax loss. You established an equivalent position within 30 days.

  • The second example is you own 100 shares of XYZ that you own at higher prices. You buy another 100 shares of XYZ on December 5. You then sell the original 100 shares on December 29 to take the loss. Sorry, not allowed, you bought XYZ within 30 days of the date of the sale.

Here are three important points about this strategy:

  1. If you make money trading and/or investing with options, you will have to pay taxes.

  2. Tax laws are specific in this area. You may not purchase the same or identical security 30 days before or 30 days after selling a security for a tax-loss. Buying a LEAPS call 31 days before selling your stock keeps you invested while risking only a portion of doubling up on stock.

  3. In-the-money LEAPS calls have high deltas (high correlation to a move higher) with low theta (time-decay). After reviewing the position at the end of January (as the SUPER BOWL approaches), you may decide that controlling a stock with a LEAPS call makes more sense than owning stock.

Portions of the previous article were pilfered from “Understanding LEAPS, Using the Most Effective Option Strategies for Maximum Advantage” by Marc Allaire and Marty Kearney, McGraw Hill, 2002.

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Options are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606.