Equity Derivative Strategies Equity Derivative Strategies Joanne M

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Equity Derivative Strategies Equity Derivative Strategies Joanne M. Hill Vice President, Equity Derivatives Goldman, Sachs & Company

Understanding the tax implications of equity derivatives and the application of these instruments for taxable U.S. clients is a challenge worth meeting. Equity derivatives can playauseful role in implementingtax-efficient strategies that maximize after-tax returns. The key is to understand the costs, benefits, and rules for applying each instrument or strategy and then to select the best instrument to accomplish the investor's objectives and minimize the taxes.

istorically, u.s. trust departments thatmanaged Capital Gains. For individuals, sales of securi H money for taxable investors were restricted in ties generally result in a long-term capital gain or loss their use of derivative securities. Because of such if the securities are owned more than 12 months. A obstacles (some of which are a matter of education holding period of 12 months or less results in a short more than anything else), derivatives are not the first term capital gain or loss. For individuals, net long tool that comes to mind for managing taxable invest term capital gains are taxed up to a federal rate of 20 ments, even though they offer advantages for many percent whereas net short-term capital gains (and clients. Derivatives are often perceived as complex in ordinary income) are generally taxed at the top mar themselves; the roles derivatives can play when taxes ginal tax rate of 39.6 percent. are involved add yet another layer of complexity. Equity derivatives, independent of any tax motiva Dividend Received Exclusion. us. corpora tion, are used for reducing the risk of holding equities tions that hold equity in other u.s. corporations may or as efficient substitutesfor equities. In bothcontexts, exclude 70 percent of dividend income from their derivatives have natural applications in tax-related income tax. One requirement is that the position be strategies. This presentationdiscusses the general tax held"at risk" for 46 days. The impactof this dividend issues facing corporate money managers or high-net exclusion is that corporations generally have an worth individuals with respect to equity derivatives, incentive to convert as much income into qualified explains how to use derivatives to maximize after-tax dividends as possible. In this regard, common and portfolio returns, discusses specific tax-efficient preferred stock are preferable to fixed-income secu derivative strategies, and provides a case studyhigh rities. lighting tax loss harvesting.' General Tax Issues Straddles. The first question to answer when discussing the tax status of a derivative transaction Before a discussion of applications of derivatives for is whether it constitutes a straddle. If a security or a enhancing after-tax returns and risk management, a derivative substantially diminishes the risk of loss of review of the general U.S.tax issues that affect the use another security, this set of securities is considered a of equity derivatives will be helpful. The most com straddle position. Straddles include hedging a mon issues are how to distinguishbetweenlong-term stock and short-term capital gains and the dividend with a swap, a long put, or a short "nonqualified" received exclusion. More-complex issues involve call (qualified versus nonqualified calls are defined straddles,stock optiontransactions, qualifiedcovered in the section "Qualified Covered Calls"). Selling calls, Section 1256contracts, and the wash-sale rule. stock index futures or stock index call options or buyingindex putsagainst a portfolio thatholds more

1I would like to acknowledge the contributions of Michael Dweck, than 70 percent of the market capitalization of the Carmen Greco, Maria Tsu, and Mark A. Zurack in conducting the index constitutes a straddlebecause it basically takes research and compiling the insights for this presentation. an indexlike portfolio and hedges it.

©Association for Investment Management and Research 69 Investment Counseling for Private Clients

Straddle situations affect taxable investors in traded. Second, they must have more than 30 days to several ways. First, the investor's holding period is expiration. Third, the strike price must be not less either suspended or terminated, which is not neces than the first available strike price below the closing sarily abadthingifthe investor alreadyhaslong-term stock price. For example, if the stock closes at $52, an capital gains. Second, and most troublesome, is the option with a strike price of $50 is the first call one inability to deduct losses to the extent that the inves could sell for it to be considered qualified. tor has an unrecognized gain. Also, financing charges Qualified covered calls can be used to extend the for straddle positions are not deductible. Instead, for holdingperiod,and theyare probablythe mostwidely the investor in a straddle situation, the charges are usedinstrumentfor deferringgains. Selling a qualified capitalized into the cost basis of the long position. covered call against a stock results in a capital gain or Finally, corporations lose the 70percent deductionon loss to the call writer, allows the holding period to all qualified dividends for stocks that are part of continue if the call is out of the money, and suspends straddle positions. Only in a few circumstances the holding period if the call is in the money. In the would a company want to do something that would example of selling the call withthe $50strike price, the constitute a straddle; corporations should generally holding period is suspended. Finally, covered calls avoid straddles. also allow for the dividend received exclusion. Stock Option Transactions. The premium re Section 1256 Contracts. These contracts in ceived or paid for stock option transactions is consid clude U.S. exchange-traded stock index futures, ered a capital item. When a physically settled stock broad-based index options, and options on index option is exercised or unassigned, the cost basis or futures, which are all accorded the same tax status as sale price can be adjusted by the premium received commodity futures. Examples of Section 1256 con or paid. Stock options, with the exception of listed tracts are S&P 500 Index futures and options, CME index options, are generally not marked to market at (Chicago Mercantile Exchange)-Nikkei futures con year end for tax purposes. The tax treatment of stock tracts, and SIMEX-Nikkei futures contracts. The options depends on the time to expiration, the type good news is that no matter how long an investor of option, and how it is exercised or assigned. holds these derivatives, any gain or loss on Section Short-dated options. Profits on short-dated 1256 contracts is treated at 60 percent long term and options are generally considered short-term capital 40 percent short term. Section 1256contracts provide gains, but losses may be considered long term if the investors the ability to sell short and obtain partial option is part of a straddle position. long-termcapitalgains tax treatmentand to make the Long-dated options. For buyers of long-dated holding period irrelevant for long-term and short options, the tax treatment depends on the holding period. For example, if an investor buys a LEAP termcapital gains tax treatment. The bad news is that (Long-term Equity AnticiPation security-that is, an these derivatives are marked to market every year; option that has 18 months, two years, three years, or therefore, a tax event occurs every year if these posi more to expiration) and holds it to term, the gain on tions remain open at year-end. In addition, investors that option will qualify as a long-term gain. are unable to qualify for 100percentlong-termcapital Call exercise/assignment. The cost basis or the gains tax treatment. sale price (i.e., the strike price) is increased by the GTC index options are not considered Section amount of premium paid or received. For example, 1256 contracts and are treated the same as single ifan investoris shorta call and sells the stock through stock options for tax purposes. Therefore, if struc the exercise of the call, the premiumis reflected in the tured with a term greater than a year and held for a selling price of the stock. year or more, gains on a long GTC option can be Put exercise/assignment. Similarly, the cost treated as long term. Also, taxes are payable follow basis or sale price of stockis decreased by the amount ing the year the option is sold rather than marked to of the premium paid or received from a put. market annually as with 1256 contracts. Cash settlement. Forcash-settled options, such as indexoptions andsomeGTC options thatare never Wash-Sale Rule. Call options cannotbe used to assigned or exercised, the premium paid or received avoid IRS Section 1091, the wash-sale rule, which does not become part of the cost basis. Options that prevents taxpayers from selling securities at a loss are never assigned are treated like a physicallysettled and reacquiring "substantially identical" securities option that is closed out prior to expiration. within a 30-day period before or after the loss sale. However, although an investor cannot sell a stock Qualified Covered Calls. Covered call options and replace it with a call option, the investor can sell must meet several criteria to be considered qualified a stock and replace it with a short put under certain covered calls. First, they mustbe listed and exchange restrictions.

70 ©Association for Investment Management and Research Equity Derivative Strategies

A short put represents the right to sell a stock at the investorcanmaximizethe long-termcapitalgains a fixed price to the writer. If I sell a put, somebody component of total return. In addition, the LEAP, like has the right to sell the stock to me at a fixed price. stock, allows the portfolio to be hedged with index The put arrangementis good news if I have a position futures or options without creating a straddle posi with a loss in it and I want to harvest it in order to tion. If the investor holds that position for more than offset a capital gain. When I sen the underlying stock, a year, the investor has a long-term capital gain and I realize my loss, and when I short a put, I give has received no dividend yield. Depending on what someone the right to sen that stock back to me at a the investor is doing with the money that is not being fixed price. If the other investor exercises the put used to buy the underlying stock, the investor could, option that I sold and sells the stock back to me, my if desired, use options to slightly leverage the posi original stock position will be reestablished. tion in the stock. Investors should keep in mind that selling a put does not violate the wash-sale rule as long as the put Asset Allocation Shifts. Index derivatives can option is not deep in the money. Thus, to harvest be used to manage asset-class or country allocations. losses and not be subject to the wash-sale rule, an The benefits are that the investor gets the 60/40 capi investor can sell a put and keep the cash in a money tal gains treatment and minimizes transaction costs, including taxes, commissions, the bid-offer spread, market account for the 31 days. This approach is a useful way of harvesting losses. and market impact. For example, consider a portfolio manager for a taxable investor who is concerned The premium from the short put can also offset about the risk of the stock market but does not want some of the potential opportunity losses if the stock to sell stocks because of the taxable gains associated turns around and rides all the way back up. To the with a sale. To reduce the risk of triggering a taxable extent that the investor believes volatilities are trad sale of stock, the managercan sell indexfutures or buy ing well above their historical levels, he or she is, in an index put option to hedge the portfolio. Instead of fact, making a strategic volatility sale on the option selling the investor's large-eapitalization U.S. stocks, premium and will have that protection toward the the manager can sell an appropriate amount of S&P upsideof the stock. Onthe 32ndday, whenthe option 500 futures contracts against those stocks to reduce expires, the investor can take the money out of fixed the portfolio's equity exposure, or if the manager income instruments and buy the stock again. wants to shift assets from one country to another, the manager can use futures contracts. But the manager Strategies to Maximize After-Tax hasto be carefulthatthe underlyingportfolio does not represent more than 70 percent of the capitalization Returns of the index; otherwise, both securities are considered In portfolio management, derivatives are simply one part of a straddle position. Generally, in addition to way to maximize after-tax returns for individual havinga low tradingcost perse, futures also have this investors. Manyderivative applications require mea desirable tax treatment. surement of asset-class or country risk. Examples are option strategies, structured asset allocation strate Creating Index Exposure. Ifan investor wants gies, and risk management. Using derivatives, port to achieve exposure to a certain index, the investor folio managers can efficiently manage portfolio can choose between index funds, separate accounts, characteristics in terms of turnover and dividend S&P 500 Depositary Receipts (SPDRs), and futures. yield, make asset allocation shifts, and achieve syn The choice will depend on the investor's specific thetic index exposure. needs. Exhibit1 provides a comparisonof theseways to gain exposure to the S&P 500. General Portfollo Characteristics. Deriva Mutual funds. Index exposure through a tives can be used to alter the general characteristics mutual fund makes tax loss harvesting difficult of a portfolio-for example, to tilt a taxable investor's because investors' funds are commingled and the portfolio toward low-yield stocks that earn more of investor might have a capital gains distribution. their returns from capital than from dividend Separate accounts. Separate accounts make income. Call options provide economic exposure to sense for investors who value tax loss harvesting a certain stock without earning the dividend yield by because an account canbe customized to fit the inves paying at expiration the difference between the stock tor's needs. Separate accounts also provide the flexi price and the option strike price. If an investor takes bility of reducing turnover by avoiding frequent a stock that has a high dividend yield, such as a rebalancing, although infrequent rebalancing results pharmaceutical stock or an oil stock, and replaces it in tracking error. Turnover tends to run 2-5 percent with a LEAP or a long-term call option on the stock, a year for most index funds and up to 20 percent for

©Association for Investment Management and Research 71

Equity Derivative Strategies

Figure 1. SPDR Market Size and Volume

14 r------, 9

8 "'~ 12 ..c:en Trading Volume ..... 1/ 7 0 (left axis) .~ 10 ;::I 6 ~ § ! ,.Q Qj 8 5 ~ ~ Qj '3 m be "0 .S 6 Fund Size 4 § "0 (right axis) ~ III ~ ...en ~ 3 .;;; 4 tE 0 .Jill- .. g}, ... 2 III.... Qj 2 ~ I I 1 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 in yield on an index, so this strategy is not necessarily a an index, the investor receives the dividends, the perfect substitute for an index fund. capital gains or losses (depending on the ending Entering into an equity swap and investing in value of the index), and the return on stock lending. fixed-income securities is similar to investing in Stock index futures and equity swaps offer means of futures contracts. Investors earninterestincome from generating index returns that are both flexible and the fixed-income investments, the total return on the efficient. specified index (gains plus dividends), less a fixed Buying stock index futures and investing in rate or floating-rate payment made to the swap coun fixed-income securities provides interest income terparty. An investor will generally be indifferent from the fixed-income investments and capital gains between buying the underlying stocks in an index or losses minus the futures premium. The futures and entering into a swap when the interest income from the fixed-income investment equals the sum of premium equals the futures price minus the current the fixed- or floating-rate payment plus the return on index value, which is the same as the index value stock lending. multiplied by the interest rate, minus the dividend Synthetic indexstrategiesprovideinvestorswith yield on the index minus the return on stock lending. several benefits compared with buying the underly Futures allow an investor to capture some long ing stocks in the index. These strategies provide term capital gain-60 percent long term and 40 per investors flexibility, operational ease, lowered trans cent short term-on trading profits, but one draw action costs, opportunities for return enhancement back with futures is that creating the economic throughmispricing, and favorable tax consequences. equivalent of an S&P500index fund involves buying Synthetic strategies also have applications anS&P500 (or a Russell index) futures contract along beyond achieving index exposure. Investors can use with a money market fund investment of the same themto equitize cashpositions and "transportalpha" material value. The money market fund may gener to another asset class. An alpha-transport strategy ate interest income that is taxable, but taxable inves enables a successful manager in one asset class, for tors can avoid the taxes by using a money market example, to transport that skill to another asset class. fund that has some tax relief from, if not federal, at Synthetic strategies are also helpful during manager least state, taxes-for example, by investing in a transitions, for implementing a global asset alloca municipal bond money market fund. Because the tion strategy, and for creating enhanced index funds. money market fund pays interest income, the taxable payoff from combining the futures contract with the Tax-Efficient Strategies money marketfund may be higher than the dividend Once investors have a strongunderstandingof deriv-

©Association for Investment Management and Research 73 InvestmentCounseling for Private Clients

ative instruments and their applications, portfolio are not. The options are out of the money at the time, managers can use these instruments to implement but they are not out of the money based on the rule tax-efficient strategies that accomplish their clients' they are supposed to be following. What the investors objectives. Three commonobjectives of taxable inves end up doing is freezing that holding period. tors are converting short-term gains into long-term Investors commit a greater error if they sell a call gains, managing market risk, and reestablishing option that is two strike prices in the money, because exposure to stocks sold at a loss. Implementing deriv not only do they freeze the holding period while the ative strategies to meet these objectives may address option is in place but they also reset the holding specific issues and provide important benefits, but it period to zero days at the expiration of the option. also may create certain risks for the investor. Managing Market Risk. Investors can manage Converting short-Term Capital Gains. A market risk and maintain long-term equity or bond good strategy to minimize the recognition of short holdings by using index futures and options on term and medium-term capital gains is to consider stocks, bonds, and indexes. For example, if an inves selling call options against the underlying stock posi tor with substantial capital gains in many securities tion rather than selling the underlying stock and is concerned about the market and would like to incurring capital gains. For example, suppose an reduce overall market exposure, she can sell stocks to investor is not as bullish now on a stock that he increase her cash holdings, but by doing so, she gen boughtnine months ago andwouldlike to reduce the erates substantial taxable capital gains. Instead, size of his position. The cost basis of the stock is $25, hedging stocks in a taxable portfolio with large gains and it is currently trading at $50. The investor can with options or hedging the overall portfolio with either sell the existing stock, buy a new stock and stock index futures are good strategies for managing have a short-term capital gain, or write a nine-month market risk and reducing tax consequences. The key call option with a $52 strike price and receive a $6 is to make sure the portfolio and the hedge positions option premium. do not create a straddle (unless she is comfortable The key is to sell a qualified call option-one that freezing her holding period). To avoid conflict with is either at the money or out of the money. Assuming the straddle rule, this investor may have to modify a long-term capital gains tax rate of 20 percent and a her portfolio to make sure that it does not represent short-termcapital gains rate of 40 percent, if the inves more than 70 percent of the market capitalization of tor sells the stock today, he will be left with $40 in the index. An alternative is for the investor to look for after-tax dollars. If the stock moves above $52, the a combination of index options or index futures that investor will generate a $33 (that is, $52 + $6 - $25) does not create a straddle. Index futures currently long-term capital gain. The investor's gain on the trade on a variety of indexes, including the Russell stock is limited because he has sold the right to own 1000 or 2000, the DJIA, and the Nasdaq 100, so put the stock to someone else. Ifthe stock trades below the ting together a basket of index options or index strike price, the option premium is taxed as a short futures that does not violate the straddle rule should term capital gain. Ifthe hedge is established, the stock not be difficult. Investors also have to be mindful of will have to drop below $39.25 for the investor to be the different tax treatments of listed and OTC indifferent between the alternatives. Thus, as long as options. the stock trades above $40, the investor is better off selling thatoption and deferring the gain. Ifthe inves Tax Loss Harvesting. An investor may want to tor sells the call option at $6 and then sells the stock at sell a stock at a capital loss to offset a realized gain in $40, the investor's after-tax proceeds will be approxi her or his portfolio. Once the stock is sold, however, mately $40 (60 percent of the $6 option premium, or it cannotbe repurchased for 31 days (without trigger $3.60, plus 80 percent of the $15 gain on the stock, or ing a wash sale), and the investor may be worried $12, plus the original $25 cost basis of the stock). about being out of the equity market during a period Investors often make the mistake of selling non when the market is appreciating, missing out on a qualified calls. If a stock closes at $56 on one day and takeover opportunity, or missing out on a favorable the next day it opens down $2 and is trading at $54, move on a particular stock during the 31-day period. some investors, believing they are not going to affect Selling put options is an efficient way to reestablish their holding period, may want to sell a call option exposure to such stocks sold at a loss. with a $55 strike price, but the qualified call option If the investor is selling a diversified group of rule is generally based on the stock's previous night's stocks, one strategy is to sell the stocks at a loss and closing price. Investors make this error especially then replace them with an index-based instrument, when stocks are having down days; they think they such as a futures contract or a SPDR, for 31 days. Ifthe are selling out-of-the-money calls when, in fact, they investor does not want to "double down," the inves-

74 ©Association for Investment Management and Research Equity Derivative Strategies

tor can sell a put to reestablish some economic expo stock from the investor. By selling the stock to a sure to the stocks. The put sale offers two important dealer, the investor gives the dealer a natural hedge advantages. First, as long as the put is not deep in the for the put option that the dealer bought from the money, it does not violate the wash-sale rule. Second, investor. At the end of the transaction, the dealer transaction costs are low because the put and stock exercises the put option and the investor can reestab sale tend to offset each otherandifthe putis exercised, lish the stock position. The benefit to the investor of the stock position is reestablished. completing this transaction with a broker/dealer is Consider an investor who owns a $50 stock that that transaction costs are very low. has a capital loss. He sells the underlying stock and thensells a putoptionon thatstockwitha strike price Case Study: Tax loss Harvesting of $55; assume he receives a $5.30 premium to rees Taxable clients need to select the stocks in their port tablish exposure to that stock. As long as the stock folios that are best suited for harvesting losses. To trades below $55,this investor will end up effectively decide among the several strategies available for repurchasing the stock at $49.70 because the option selecting stocks for harvesting tax losses, the portfolio buyer will be happy to exercise the right to sell that manager needs to consider the client's objectives and stock at $55. other important issues. The investor may want to The downside of the strategy is that if the stock harvest tax losses efficiently to offset taxable gains on plummets to $30,the investor will have to pay$55for other assets or to rebalance the portfolio to improve the stock when the option buyer exercises the option, correlation to a benchmark. but if the investor had not sold the stock or the put Important issues to consider before implement option, the stock would still be worth $30. The con ing a harvesting strategy include sequences on the downside are similar to being in the • determining the criteria for prioritizing the har stock itself. vesting process, On the upside, if this stock appreciates signifi • estimating the marginal tax benefit assigned to cantly by expiration of the option-to $60, $65, or any realized losses, even $70-the investor's put optionwill expire unex ercised. Then, to reestablish the position, he will have • deciding which stocks to replace immediately to buy that stock in the marketplace for whatever and which stocks to repurchase 31 days later, price it is trading for at the end of the 31 days. The • assessing whether the extent of harvesting will investor receives the putpremium,however, as some affect the degree of rebalancing needed to compensation for having taken that risk. This strat improve the correlation to the benchmark, and egy is clearly better than being altogether out of a • choosing strategies to manage exposure during stock that appreciates significantly. the 31-day period. The structureand timingof sucha transaction are Three strategies are available for prioritizing the illustrated in Figure 2. In this illustration, the broker/ tax-lass-harvesting process. Some of my colleagues, dealer is taking the other side of the trade, but the Mark Zurack and Maria Tsu, have recently con investor could also simply sell the put option in the ducted a detailed analysis for a taxable client of the market. The investor has, say, 100,000shares and sells relative merits of these strategies. The strategies yield 30,000 shares in the market and 70,000 shares to the similar results if almost all of the losses are realized broker/dealer. The transaction implicitly assumes (i.e., if greater than 95 percent of the losses are har some delta hedging and that the broker/dealer is vested) but differ in efficiency if the client wants to buying the put option and some of the underlying realize a smaller portion of the losses.

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

Stock < $55, Sells 70,000Shares Exercises Put ~~ Broker/ ~ Broker/ Investor Dealer ~~ Dealer e ~ ------Sells 30,000 Sells Puts Stock> $55,t Receives Stock Shares Buys Stock Market G

©Association for Investment Management and Research 75 Investment Counseling for Private Clients

Strategy 1 is to harvest stocks if the marginal benefit Table 1. Percentage of Stocks with Losses exceeds the marginal cost of transacting. Strategy 1 is Harvested applicable if the marginal tax benefit for realized Percent of Strategy 1 Strategy 2 Strategy 3 losses is 25 percent of the realized loss and the mar Losses (MB> MC)a (by % loss) (by $ loss) ginal cost is 1percent of the notional value of the stock 80 57.7 46.9 64.2 sold (including round-trip commission costs and the 85 63.1 52.9 70.0 market impact of trading). 90 67.5 60.3 75.4 Strategy 2 involves minimizing transaction costs 95 73.9 70.6 80.9 versus the value of losses realized by harvesting 99 87.3 87.2 90.5 stocks with the largest percentage loss first until the "Marginal benefit exceeds marginal cost of transacting. desired amount of losses is harvested or a target level of turnover is reached. This strategy can apply whether or not the investor uses put options. loss-harvesting strategy. Strategy 3 involves harvesting stocks with the Managing Exposure during the 31-Day largest dollar loss first untilthe desiredamountof losses Period. At least three approaches exist to mitigate is harvested or a target level of turnover is reached. the exposure during the 31-day waiting period Strategy 3 is less efficient than Strategies 1 or 2. needed to avoid a wash sale: holding cash, buying As the comparison in Table 1 shows, if95 percent or SPDRs, and selling a put option on the stocks to be less of the available losses are harvested, Strategy 2 repurchased in 31 days. Each strategy has distinct provides the most efficient means of harvesting. In Strategy 2, an investor can harvest 85 percent of the advantages and disadvantages. losses by selling 53 percentof the value of stocks with Holding cash. This approach is quite simple losses. Thus, the investor will realize the highest for investors; it involves no transaction costs and no percentage of losses among the smallest percentage loss of principal if the market declines. But investors of stocks. Figure 3 shows the relationship between will experience a drag on performance if the market the percentage of realized losses and the percentage rebounds. Holding cash will also earn investors less of stocks with harvested losses for the three strate than selling put options. gies. Unless the percentage of available losses BuyingSPDRs.This methodreduces tracking exceeds 95 percent, Strategy 2 remains the best tax- risk relative to a benchmark and provides market

Figure 3. Performance of Strategies for Harvesting Tax Losses 110 ~------,

100

80 /, Strategy 3

.' Strategy 1

20 ..

o w:.... -' ~J. . o 20 40 60 80 100

Percent of Stocks with Losses Harvested

Note: Indicative pricing as of October 7, 1998.

exposure ifthe marketrebounds. Drawbacks include Table 2. Example Strategy of Selling Puts the transaction costs to buyand sell SPDR shares and BasketPrice Put Value Purchase Price Effective Price the condition that buying SPDRs provides no offset $ 92 $15 $107 $ 99 to stock-repurchase costs. 93 14 107 99 Selling puts. An investor who follows this 94 13 107 99 approach will obtain an up-front option premium, 95 12 107 99 which lowers the investor's cost basis. Transferring 96 11 107 99 stock to a dealer (as shown in Figure 2) reduces the 97 10 107 99 market impact of selling stock. Complexity and per 98 9 107 99 99 8 107 99 formance lags if the market rises rapidly are major 100 7 107 99 disadvantages of selling puts. In addition, the effec 101 6 107 99 tive purchase price of reestablishing stock exposure 102 5 107 99 may be above the current market price if the market 103 4 107 99 declines sharply. 104 3 107 99 Figure 4 demonstrates the payoff from selling 105 2 107 99 puts for a client who wants to sell a put option on a 106 1 107 99 $50 million basket of 300stocks with a dividend yield 107 0 107 99 108 0 108 100 If of 1.95 percent to be repurchased in 31 days. the 109 0 109 101 stock falls significantly during the 31-day blackout 110 0 110 102 period, the investor is better off simply liquidating Note: Indicative pricing as of October 7,1998. the position. With the currentbasketprice at $100,the clientsells a putwitha $107strikepricefor a premium of $8. Table 2 indicates that as long as the basket remains below $107, the effective cost of reestablish Conclusion ing the basket of stocks is $99. At prices above $107, Equity derivatives are useful instruments for maxi the put option expires worthless but the initial pre mizing the after-tax returns of a taxable investor's mium helps offset the cost to repurchase the stocks.

Figure 4. Payoff from Seiling Puts 115

110 Purchase Price if Put-, Not Sold

t Effective Price ifPut Sold

85 L-_---l.__--L..._-.J__~__..l...__ _..l..___'__ __'___'___ __' 92 94 1041021009896 108106 110 112

Market Price of Basket ($)

portfolio because they offer alternatives to high Investors and portfolio managers need to under dividend stocks, provide a way to implement asset stand the general tax issues surrounding equity allocation shifts, or allow the creation of synthetic derivatives before considering using them. Impor index exposure. Equity derivative strategies can also tant considerations are the rules involving straddles, be used to efficientlyconvertshort-termcapital gains qualified covered calls, and wash sales. Also vital to into long-term capital gains, reduce the implemen effective use of equity derivatives is an understand tation risk as a tax-lass-harvesting strategy by helping investors manage market risk during the 31 ing of what each instrument or strategy can and day lock-up period associated with avoiding wash cannot do; the benefits, risks, and costs of each strat sales, and maximize the benefits of tax loss harvest egy; and most importantly, the tax implications of ing. alternative strategies.

78 ©Association for Investment Management and Research Equity Derivative Strategies Question and Answer Session Joanne M. Hill Carmen Greco2

Question: Are SPDRs consid trust holdings. Large institutions them use SPDRs for hedging ered Section 1256 contracts? often arbitrage SPDRs by accumu because they don'twant any extra lating a number of units and con paperwork and their charters Hill: No. Section 1256 contracts verting them. allow the use of SPDRs. They sen include futures or options that You have to take tracking risk SPDRs short for asset allocation trade on a listed exchange. Section to hedge the market risk of a port and hedging purposes. 1256 contracts were initially creat folio that isn't a perfect replica of ed to apply to commoditiesfutures the benchmark index. So, SPDRs Question: Is shorting a SPDR contracts. When index options provide the tax advantagebut take against a diversified portfolio started trading on the Chicago away the tracking benefit. considered a straddle? Board Options Exchange, the SPDRs trade at different prices CBOE wanted to make them from the index because they track Hill: If that portfolio contains comparable in terms of tax treat futures, in the following sense: If more than 70 percent of the market ment to futures index options that the market goes down sharply on cap of the S&P 500, then shorting trade on the Chicago Mercantile the last day of the month, futures the SPDR constitutes a straddle. Exchange. Initially, the Section will go out cheap and end up sell The 70 percent rule also applies if 1256 contracts were brought in to ing below where they should. you go on the other side-long a include index options, but for tax Why? Because traders are in the SPDR and short a diversified purposes, SPDRs are treated like market hedging since they cannot portfolio. the purchase or sale of a stock. The easily shorta stockportfolio. There primary disadvantage of SPDRs is is a plus tick rule, but investors can Question: In selling call options that you pay a commission to sell futures, so futures are trading to convert short-term capital gains purchase one, but if you hold the cheap. The market maker of the to long-term term capital gains, if position a long time, the commis SPDRs, who is a specialist on the you write a $52-strike call and the sion is amortized over a long floor of the exchange, will now stock immediately goes through period of time. adjust the SPDR price based on the strike price, are the capital When an investor buys a where the marketmakercanhedge gains on the stock still long term? SPDR,the investordoesnotreceive his or her position in the futures exactly the same return as the S&P market. So, the market maker is Hill: Going through the strike 500. For example, if you mark the making a market based on the price has no effect as long as the SPDR at the end of a month and hedging instrument, which is the option holder does not exercise the calculate the tracking error of that futures contract. SPDRs will go out option. But if the option gets deep SPDR position to the S&P SOD a little bitbelow the index on a big enoughin the money thatsomeone return, the error will be 1O()-.140 down day or above the index on a exercises it prior to expiration (12 basis points. In other words, a port big up day. On a big up day, every months), then the other side will be folio performance report at theend body comes in and buys SPDRs forced to sell the stock. Exercising of any month for SPDR positions because they want to capture that an optionearlyis irrational (it'snev will not be marked where the S&P move. So, a potential marking risk er optimal to exercise options early 500 closes that month but where is present at the end of a, say, quar froman option-pricingstandpoint), the SPDR closes that month. Ifyou terly performance period that but such things do happen, espe accumulate enough SPDR shares, introduces some tracking error. cially before a dividend payment. the shares can be converted into That error washes out, however, units of the trust and you can actu over an annual period. Greco: A physically settled op ally take physical delivery of the tion entails no tax on the option. Greco: An advantage of SPDRs Options take on the holding is that you don't need a plus tick period characteristics of the stock 2CarmenGreco, whoworks withMs. Hillin the area of equity derivative strategies at to sell them short. So, when man position, so if you enter into a Goldman Sachs, joined Ms. Hill for this agers are not allowed to use physically settled option, you question and answer session. derivative products, many of actually deliver your stock. If the

stock is held for 12 months and a and is not happy. There is not knowledgeable about derivatives day, it will trigger a long-term muchthe clientcan doaboutit. But and then have them go to brokers, capital gain that is equal to the exit if a client has a loss on a derivative exchanges, industry educational strike price plus a premium. For contract, the client will probably organizations, or experts for edu example, if you sell the $50-strike lookfor ways to getoutof realizing cation. AIMR, the FuturesIndustry call for $5 and you have a zero cost that loss. And the client might say Institute, and the Options Industry basis,you'refacing a $55long-term that you were not authorized to Institute regularly run educational capital gain, but you can convert trade derivatives. programs on derivative strategies. long-term gains to short-term Marked-to-marketrisktips the Second, one or two in-housestaff gains if you settle the option for scales in favor of trading listed or on the trading desk and in cash. To remain flexible, however, exchange-traded instruments. research-should specialize in you need to be leery of physical Listed markets broadly dissemi equity or fixed-income derivatives settlement. A customized option nate closing prices, of course. The to be a resource to the portfolio allows you to stay flexible as long possibility always exists that the managers in helping them with as you don't have restricted stock. option market will be disrupted in strategies. Anotherareawhereyou an emergency situation, but recent need a derivatives expert is in the Question: Hedging with put revisions in the circuit breakers risk management group. Start-up options and short calls (collars) to reduce thelikelihood thata closing costs are involved, but you need minimize concentration risk re price cannot be established at the people in your organization who quires liquidity in the security. end of each trading day. spend at least 50 percent of their What other strategies are feasible Growthin stockoptionvolume time on risk management. for relatively illiquid securities? has been 2(}-30 percent in the past three years. Stock options are regu Greco: One of the best books on Greco: Stock borrowing and li larly used as part of corporate buy options is the reference book quidity are the first things we look back programs, hedging single Options asa Strategic Investment. 3 It at in termsof engagingin a strategy stock risk, and covered call writing. is long on strategies and short on because we do not take a direction A goodbalanceexists betweenbuy math, and it does a good job of al view on the stock. We hedge our ers and sellers in single-stock explaining how strategies work, positions, and that practice is options, so options don't contain how to implement them, how to pretty consistent throughout the much hidden risk-s-as long as you get out of them when things go investment community. Ifsome are usingoptionsin an unleveraged wrong, and (because it is written one can'tborrow the stock and the way. Some kind of leverage test is underlying stock has no liquidity, always a good idea, which does not for the high-net-worth individual) peoplewho take on a counterparty mean that you should never use how to optimize returns from a tax position will not be able to leverage. Ifyou are using leverage, standpoint. maintain an economically neutral however, you have to make sure position throughout the life of the you are authorized to do so and are Question: Are investment advi trade, so theywillnotengagein the notdoingit surreptitiouslythrough sory firms or trust companies trade in the first place. a derivative. using derivative strategies to con trol fee revenue? Question: What are some of the Question: What approach to risks that one should be wary of in recognize which strategies are Hill: Yes, somewhat, but the entering into these kinds of con legitimate would you suggest for practice is not widespread. We tracts? investment advisors who are not have received a number of inquir well practiced in the use of options ies about hedging fee income, but Hill: First, there is documenta and derivatives? fewer than 10 percent of institu tion risk. You should make sure tions use derivative strategies to that your client is educated about Hill: First, try to involve a broad control fee revenue. all the features of these derivatives group of people in the organiza The logic of such hedging is and that yourinvestment advisory tion, induding operations, legal, dear: The fees that many invest agreement dearly authorizes you and custody staff. Not everyone ment management organizations to engage in options and/or needs to know all the nuances of 3Lawrence G. McMillan, Optionsas a Stra futures transactions. Itis one thing derivatives, but you should iden tegicInvestment: A Comparative Analysis of if the market falls 50 percent and tify at least two people in each area ListedOptionsStrategies, 3rd ed. (New York: the client owns a stock portfolio of the organization to become New York Institute of Finance, 1993).

earn are based on the portfolios stock of public securities manage larger entities, publidy traded they manage. Their fees are sensi ment firms precisely for their sensi entities, or non-publicly-traded tive to the gains and losses on equi tivity to certain markets. For entities withbudget goals. Most of ties (and on fixed-income example, investors buy T. Rowe the cases we havebeeninvolved in instruments, to some extent, ifthey Price because itis an equity-related have been situations in which a are fixed-income managers). And firm. Ifyou hedge awaythe market firm is midwaythrough the year, is if a firm has sensitivity to the sensitivity, you changethenatureof wen in excess of its budgeted fee equitymarket, it can hedgethe risk the firm andinvestors are no longer income, andis wining to paya little with an index option. buying an equity-related firm. amountof the excess of thefee bud The reason for not using deriv The transactions that we've get or target to make sure those ative strategies to hedge fee income done tend to be for financial insti gains will be realized or to hold is that shareholders are buying the tutions that are subsidiaries of those gains through the year.