Hedging Tip of the Week #1

Posted on March 7th, 2012

Spreads fit nicely in Tax Deferred Accounts

We are starting a new series called Hedging Tip of the Week. In it, we will pick some short educational topics that we explain in 2 paragraphs or less. This week’s tip is about using spreads in tax deferred accounts.

Call and put spreads are very good fits for tax deferred accounts like IRAs. We use spreads to create hedged positions – but like to set our expirations at 6 months or less from today. As a result, we create a lot of taxable events in the buying and selling of these options. These events are always short-term in nature so they would get taxed at regular taxable income rate. The way to avoid the taxable consequences: place these trades in your IRA account.

In fact, consider using call or put spreads to control more shares of a broad index ETF in your IRA than you could control if you just bought the ETF outright. Remember that spreads are more capital efficient and you can control more shares with significantly less money. Instead of keeping this cash in your IRA – use it to control more contracts in your spread. Then, adjust your investments in your OTHER investment accounts. Whatever you do – don’t permit your implied leverage across ALL of your portfolios to exceed 1.0x. And I also recommend keeping your implied leverage within the IRA to less than 2.0x. You don't want your IRA to get blown out of the water either!


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2 Comments

Rick - March 12th, 2012 at 12:32 PM
RE: “As a result, we create a lot of taxable events in the buying and selling of these options. These events are always short-term in nature so they would get taxed at regular taxable income rate.”nnI believe RUT, SPX, NDX etc. are subject to section 1256 as far as taxes go. This will result in 60% long term and 40% short term capital gain.nnCorrect me if I am wrong on this!nnThanks,nRickn
Jay Pestrichelli - March 12th, 2012 at 3:58 PM
Rick, you are 100% correct on the tax treatment of the NDX, SPX, OEX, and RUT. Those vehicles do get special treatment because they are considered futures contracts and qualify for the rule 1256 tax treatment. I would say these are some unique exceptions to the rule.
As for deciding where to do these taxable trades, there still is the 40% portion that is treated as short term. While the net is dramatically lower than if 100% was treated as short-term, it is still probably higher than what you pay in a tax deferred account.

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