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Author: jchoy Two stars, 250 posts Ticker Guide Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 120826  
Subject: ot: taxes/options/arbitrage? Date: 8/28/2012 10:15 AM
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i posted the same thing in the berkshire board and was suggested to post it here:

Here's an interesting situation i thought of. If i have a portfolio of realized short term losses, short term gains, long term losses, and long term gains, I believe ST losses first offset ST gains before offsetting LT gains.

In the US, when short option positions are closed, they are always considered short term losses/gains, regardless of the holding period. But long option positions held over a year are considered long term loss or gains.

Say the S&P is trading at 1400.5, and options trade at a $1 increments. I put on a bull call spread between 1400 and 1401 for about $.5. Now more than a year goes by, and the S&P is now at 1500. The net profit on the position is $.5. But individually, the profit on the long option is going to be at around $100, and the loss is going to be around $99.5. Since the short call option is bearing the loss, it's counted as a short-term loss. The long call has a long term gain. If these were the only two transactions, it would pretty much be a wash ($.5 profit taxed at LT rates).

However, if i were a day trader, and over the course of the prosperous year, I'd racked up a short term gain of $99,500 (same as the loss on the short call). I would then be able to allocate the "short term losses" from the spread to the gains on the day trades, and have the long call taxed at a lower rate. Putting the trade on for that cheap is essentially a free tax hedge. Thoughts, anyone?
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Author: Bob78164 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116559 of 120826
Subject: Re: ot: taxes/options/arbitrage? Date: 8/28/2012 3:25 PM
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jchoy writes (in part):

Say the S&P is trading at 1400.5, and options trade at a $1 increments. I put on a bull call spread between 1400 and 1401 for about $.5. Now more than a year goes by, and the S&P is now at 1500. The net profit on the position is $.5. But individually, the profit on the long option is going to be at around $100, and the loss is going to be around $99.5. Since the short call option is bearing the loss, it's counted as a short-term loss. The long call has a long term gain. If these were the only two transactions, it would pretty much be a wash ($.5 profit taxed at LT rates).

However, if i were a day trader, and over the course of the prosperous year, I'd racked up a short term gain of $99,500 (same as the loss on the short call). I would then be able to allocate the "short term losses" from the spread to the gains on the day trades, and have the long call taxed at a lower rate. Putting the trade on for that cheap is essentially a free tax hedge. Thoughts, anyone?


I reply:

It sounds like the sort of thing that's covered by the straddle rules of 26 U.S.C. § 1096. --Bob

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Author: jchoy Two stars, 250 posts Ticker Guide Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116560 of 120826
Subject: Re: ot: taxes/options/arbitrage? Date: 8/28/2012 5:08 PM
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ahh interesting. I'll look more into that. thanks!

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Author: loopholes One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 116562 of 120826
Subject: Re: ot: taxes/options/arbitrage? Date: 8/31/2012 8:30 PM
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Your hypothetical involves sec 1256 contracts, so in your predicate case, you would not have more than a year go by before you'd have to account for the gain and loss on your respective long and short positions. You would have to MTM your positions at the end of year 1, and your gain on the one leg is 60% LT/40% ST, and your loss on the other leg is also 60%LT/40%ST.

I don't see a different result in your second example, but I'm not sure I understand the facts.

If the options were not Sec. 1256 contracts/nonequity options (see pub 550), the 60/40 rule would not apply, you would not MTM at year end, and as another poster mentioned, you'd have a straddle. The straddle rules generally prevent you from recognizing a loss on a closed out position if (and to the extent) you have not recognized the gain on the offsetting positions.

So, in the first example, if you don't have 1256 contracts and don't MTM, and you are closing out both positions in year 2 at a net gain, the loss deferral of the straddle rules don't really affect you. You'd have LTCG on the long call and STCL on the short call. On its face, that seems suboptimal. But, in a closed universe where the only capital gain/loss you recognize is from closing out these positions, you reduce your gain to $500 by netting the loss, and your tax rate on the net gain is the lower LTCG rate. Not too shabby.

In the second example (again, not sure I understand the facts), but assuming you've recognized the gain in multiple profitable trades over the course of the year, all the gain would be ST. If you also closed out the short call/loss position, the offsetting loss also would be ST. So again, assuming the closed universe, you'd net STG and STL; but in this case, your $500 net gain would be STCG. I don't see that as a better outcome than in the first example. Psychologically, it might feel better because you're not having to net your STL against low taxed LTG. But you're actually worse off, because your tax on the net gain is higher.

If I misunderstood the facts, and you actually left the loss leg unrecognized, again you don't have a straddle problem, but you also wouldn't have an offsetting recognized loss, and all your gain would be taxable STCG. That'd be really suboptimal.

Where you'd have a straddle problem would be if you decided to close out the short call/loss position, and let the gain leg ride (i.e., accelerating tax benefit of the loss but deferring tax detriment of the gain). You would not be able to take the loss to the extent of unrecognized gain in the long call, until you closed out the long call.

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