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‘Protective collar’ approach can shield investors if a stock falls while also providing upside potential and deferring tax on the shares

iStockphoto

My friend Todd is losing sleep. Why? Because the shares he purchased in a certain company are dropping in value. "What's wrong with the company?" I asked. "I dunno," he replied. "It seems the stock is falling because of a prediction of speculation that there will be rumours of bad news – or something." Todd has thought about selling his shares, but he's got a large capital gain, and selling would trigger a large tax bill in 2016. He'd love to defer his sale – and the tax bill – to the new year, while not worrying about the declining value in the meantime.

He's able to accomplish this with a strategy using options. It'll protect him on the downside if the stock falls, provide some upside potential and allow him to defer the tax on the shares.

The strategy

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Todd owns 100 shares of XYZ Corp. that cost him $25 a share. Today, they're worth $50. He's concerned about locking in his profits. He's decided to use a "protective collar" that involves two types of options. First, he's going to purchase a put option on his XYZ shares. This option gives Todd the right, but not the obligation, to sell his shares for $45 (the strike price) at any time in the next 12 months. The put option is going to cost him $4 a share, or $400 in total.

The strategy also involves Todd writing – that is, selling – a call option on the XYZ shares. This call option will give the buyer, or holder, of the option the right to buy XYZ shares from Todd for $65 a share at any time in the next 12 months. This call option is going to cost the buyer $600, which will be paid to Todd.

The results

Now, suppose XYZ continues to drop in value below $45. In this case, Todd can exercise his put option and sell his shares for the $45 strike price. Since he paid $25 a share, he's guaranteed to realize a $20 gain ($45 less $25) per share, for a total gain of $2,000 on 100 shares, plus the difference between the price he paid for his put option ($400) and the income received on the call option ($600) – a net $200 profit. Todd can rest easy today and sell his XYZ shares next year. He'll pay tax on his capital gain next year when the shares are sold. The call option will expire since the holder of that option won't want to buy XYZ at $65 when they sell for under $45 on the open market.

What if, instead, XYZ shares increase in value to, say, $70? In this case, Todd's put option will expire worthless (he's not going to sell his shares under the option for $45 when he can sell on the open market for $70). The holder of the call option will exercise her right to buy the XYZ shares from Todd for $65. He'll miss out on the growth in value above $65, but he'll still have a profit of $4,000 ($65 less $25, for a gain of $40 per share X 100 shares). He's also earned the $200 net profit on the difference between the put and call option premiums.

If the XYZ shares don't change in value, the put and call options expire and Todd will keep the $200 net difference between the put and call option premiums. As an aside, Todd could have skipped the call option side of the strategy. He'd gain greater upside potential, but he'd also forgo the income from writing the call option.

The tax

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There are a couple of tax implications to the protective collar strategy. First, Todd has managed to defer the tax on his capital gain to next year without worrying about a continued decline in the value of XYZ shares.

Next, each option – both the put and call – has its own tax implications. Todd paid $400 to acquire the put option. If he sells his XYZ shares next year, the $400 cost will reduce his proceeds of disposition, which will reduce his capital gain. If the put option expires, Todd can claim a capital loss for the $400 in the year of expiry.

As for the call option: Todd received $600 when he sold the option. If the option is exercised by the holder, the $600 is added to his proceeds of disposition of the shares in the year of exercise. If the call option expires, the $600 is reported as a capital gain in the year he received the amount (not in the year of expiry).

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.

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