How Hedging Can Afford Investors Tax-Planning Opportunities

by Wayne Ferbert on November 16th, 2011

Our new book from Minyanville Media, Buy and Hedge: The Five Iron Rules for Investing Over the Long Term, doesn’t mince words: If you are going to be a Buy and Hedge Investor, you need to hedge every investment! It is the very first Iron Rule for Investing.

But did you know that hedging affords the investor some interesting tax-planning opportunities? Hedging creates some interesting tax consequences. This article will walk you through the placement of long investments in one account and your investment hedges in another account. And by placement, I mean the ability to house your investment hedges in a taxable account while placing your underlying investments in a tax-advantaged account.

The best way to hedge is using options, and options have expiration dates. As a result, the hedged investor has to follow a routine to regularly update his hedges when the hedges reach expiration. The Buy and Hedge investor does this so that he maintains the proper hedged exposure. This routine creates buy and sell transactions on a periodic basis in your accounts. As you already know, these transactions all have potential tax consequences.

If you read the book, you know that your tax situation is important to manage. The only investment returns that matter are your after-tax returns. This creates some interesting tax management opportunities for the Buy and Hedge investor.

To be properly hedged, you must build downside protection in to your portfolio. In fact, the definition of "hedged" in the book is that you have limited the total loss your portfolio could incur in a worst-case scenario. One of the most popular hedging techniques I and co-author of the book Jay Pestrichelli teach is building a collar.

A collar is when you own a stock and then you purchase an Out-Of-The-Money (OTM) put as protection for the stock. And you also sell an OTM call on the stock to complete the collar. When using this technique, the protection is the OTM put. It protects your stock in the event of a decline below the strike price of the put.

As hedged investors, we look to protect ourselves from the unforeseen market events that can damage our portfolios – just like we buy insurance for the unforeseen disasters that can damage our homes. Like our homeowners insurance, we hope we never see the hedges pay off. In other words, we hope the hedged protection never needs to be used.

We would all prefer a consistent upward-moving market that appreciates steadily. But we, as students of the market, know that markets will always have corrections as long as fear and greed get to play a role. While less than 5% of homeowners ever file a large claim for a disaster, we can guess that close to 99% of individual investors suffered material portfolio losses in the 2008-2009 market collapse.

While being hedged in 2008-2009 would have been great in retrospect, you would have only likely been hedged if you were implementing a regular routine hedging strategy. And that hedging strategy certainly would not have produced any payoffs in the hedges in 2007 or the first half of 2008. The hedged investor would have had regular hedge investments that would have expired worthless ahead of the big hedged payoff in 2008/09.

In other words, for every hedge that pays off, the hedged investor will probably have many hedges that expired worthless or were closed at a loss. And the inverse is true for the covered call portion of your collar. Most of the time, your covered calls will expire worthless also – which represents a gain for the hedged investor. Managing these regular gains and losses across your investment accounts is key to maximizing your after-tax returns.

If you have an IRA account that represents a material amount of your investable assets (at least 20% or so), then you can use this IRA account to be more efficient with your hedging approach. The solution is simple and you probably figured it out from the last paragraph. Place your stock/ETF investments in your IRA account. And sell the covered calls within the IRA account also. But purchase your OTM put protection in your taxable accounts.

This approach will help you avoid taxes on the two investments you are targeting for gains: your underlying stock/ETF and your covered call. This is especially important for your covered calls. After all, these are monthly calls that would be short-term gains if they were in your taxable account. The gains on these calls would be taxed at short-term tax rates if they were in a taxable account. By housing them in an IRA, you can keep growing these assets with paying taxes.

Meanwhile, you should purchase the put protection in your taxable accounts. Ideally, this protection never ends up in the money – and the markets just appreciate at a steady rate. These options will likely expire worthless most of the time. These will create regular losses in your taxable accounts that you can pair off against any gains on other positions in your taxable accounts. Or, if you can’t pair them off, then you can just carry the losses forward. After all, these hedges will likely pay off one day in the future creating a taxable gain – potentially a sizeable gain. Having an accumulated loss carry-forward to match up against the profit from the hedge – if and when that day comes.

Our financial advisor implements this strategy for all of our clients that have both an IRA account and a taxable account. We even implement this strategy for one client that has a 401k account – though this option is very rare as most 401(k)'s don’t offer that kind of flexibility. And this approach works for married puts also – another tactic we discuss in our book. Ultimately, this approach is great for optimizing long-term wealth for retirement – but only for the hedged investor!

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Minh Vuong - November 23rd, 2011 at 5:11 PM
Excellent suggestion - makes good sense.

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