Bull markets, bear markets. How do you define these things anyway?
Some would define a bull market as a random market movement causing the average investor to mistake himself for a financial genius. As for a bear market? It's a six- to 18-month period when the kids get no allowance, and Dad buys no new toys. That's where we're at today.
A bear market might cause you to lose some sleep. But it can also create a tax dilemma.
Gerald's story is common. Gerald purchased shares a couple of years ago that have done very well, although the recent market volatility has taken back some of the profits he's earned. He's concerned that the stock's price will continue to drop, so he's thinking about taking his profits by selling the shares very soon.
The problem? If he sells his shares in 2008, he's going to be hit with a tax bill equal to nearly 23 per cent (at the highest marginal tax rate) on the realized capital gain.
Let's face it, if Gerald is going to pay tax on his gains, he'd rather defer the tax to a future year, allowing him use of those tax dollars in the meantime. Enter the put option. A put option will allow you to defer tax on your capital gains until a future year while still locking in the gains you've made on your shares to date.
Put Options
A put option will give you the right, for a fee, to sell a stock at a specific price (the strike price). The option is only good for a fixed period of time, but acts as an insurance policy against declines in a stock's value.
For example, Gerald paid $30 a share for his investment in XYZ Corp., and the stock is now trading at $42, but the price is on the way down. He wants to lock in the $12 gain he has made without selling his XYZ shares.
A call to his broker revealed that he can buy a put option, giving him the right to sell shares of XYZ at $42 until January, 2009. Gerald owns 100 shares of XYZ and he paid $215 ($2.15 a share) for the put option.
Gerald now has downside protection. Here's how: If the value of XYZ declines below $42, Gerald's option increases in value because it gives him the right to sell at $42.
The option's increase in value will offset the decline in the stock's value. So, he's protected.
What if the stock price rises above $42? Gerald will still benefit from this increase in value because he's still holding XYZ shares. In this event, the option will now be worth less than what he paid, but the most he'll lose is the $215 he paid for the option.
Now, you may wonder whether you can even buy put options given the recent market volatility. The answer is yes. The premiums may cost more today than a year ago, but they're available.
The Results
With the put option in place, Gerald can now hold his XYZ shares until next January and sell them at that time if he chooses.
The result? Gerald will pay tax on his capital gains in 2009, not 2008. He has managed to defer his tax liability for a year while protecting himself from any declines in the value of his shares until he's ready to sell them.
Depending on the stock, it may be possible to purchase a put option that will allow a sale to be deferred beyond 2009, deferring tax even longer.
Keep in mind that it will be important to buy an option that is not due to expire until a future year. This will allow you to hold your shares until that future year before triggering a taxable capital gain.
And make sure that the cost of purchasing the option will be outweighed by the actual taxes saved and the benefit of the taxes deferred.
You can often accomplish the same tax deferral by selling short the stock that you also own, but there are three drawbacks to this.
1. There could be complications if a ban is imposed on short selling the particular stock.
2. You'll rob yourself of any upside potential if the stock price rises.
3. Unlike the put option, any profit on the short sale will be fully taxed as regular income, not as a capital gain, which is just 50 per cent taxable.
