Future Tax Issues with Options
Tax problems and strategies have been made very complex by the current tax rules and, hopefully, future reforms will simplify those rules or make them easier to follow. However, taxes are only one of the many challenges you face in deciding how to plan your investment portfolio, determine which risks are acceptable, and protect capital for your future.
Options, like all investments, should always be used in the context of your individual plans.
ExampleDefining Yourself and Your Goals: You have written down your personal investing goals, and have identified what you hope to achieve in the intermediate and long-term future. You are willing to assume risks in a low to moderate range. So all of your capital is invested in shares of blue-chip companies. In order to increase portfolio value, you consider one of the following two possible strategies:
- Strategy 1: Hold shares of stock as long-term investments. Aim for appreciation and continuing dividend income.
- Strategy 2: Increase the value of your portfolio by purchasing shares as described above, and waiting for a moderate increase in value; then begin writing covered calls. As long as your minimum rate of return, if exercised or unchanged, will always exceed 35 percent, you will write a call and then avoid exercise through rolling techniques. If a call is exercised and stock is called away, you plan to reinvest the proceeds in additional purchases of other blue-chip company shares.
An interesting point to remember about the covered call strategy, especially as described in strategy 2: The common argument against writing covered calls is that you may lose future profits in the event the stock's price rises dramatically because your striking price locks you in. It is true that, were the stock's market value to climb dramatically, you would experience exercise and lose those profits. However, remember that well-selected stocks will also tend to be less volatile than average, so that the chances of such increasesâwhile they can happenâare lower than average. In addition, covered call writers take their double-digit returns consistently in exchange for the occasional lost paper profit. The goal of long-term growth is not inconsistent with writing covered calls, as long as you have a plan and stick to it, and as long as exercised shares are replaced with other shares of equal growth potential.
Every form of investing contains its own set of opportunities and risks. If you lose money consistently in options, you will also tend to have the following characteristics: You do not set goals, so you do not have a preestablished plan for closing positions profitably. You do not select strategies in your own best interests, describing yourself as conservative while using options in a highly speculative manner. You believe in the fundamentals but you follow only technical indicators. You have not taken the time to define your risk tolerance level, so you do not know when the risks you are taking are too high. A popular maxim in the investing community is, "If you don't know where you're going, any road will get you there."
As a successful investor, you are focused. You take the time to define your goals carefully, and you define your risk tolerance level with great care. You also define yourself in terms of what works for you and what doesn't work. This enables you to use strategies that make sense and to resist temptation when you receive advice from others. You also tend to be patient, and you are willing to wait for the right opportunities rather than taking chances when conditions are not right.
Devising a personal, individualized strategy is a rewarding experience. Seeing clearly what you need to do and then executing your strategy successfully gives you a well-deserved sense of achievement and competence, not to mention control. You will profit from devising and applying options strategies based on calculation and observation. You will also benefit from the satisfaction that comes from mastering a complex investment field, and finding yourself completely in control.
Because calculations of marginal profits often do not include consideration of the tax consequences, you need to always keep the tax rules in mind when judging various strategic approaches to options trading.