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Chapter 41 Hedging and option strategies.

WHAT ARE THEY?

The Chicago Board Options Exchange defines hedging as "a conservative strategy used to limit investment loss by effecting a transaction that offsets an existing position." (1) In essence, hedging is a form of investment insurance, which, like traditional life, property, and casualty, or liability insurance, transfers risk from one person or entity to another. And, just like traditional insurance, hedging involves tradeoffs. Hedgers may have to pay a "premium" or be otherwise willing to forego potential investment returns to shift risk.

Quite frankly, as many possible hedging strategies exist as the creative mind can structure. In addition, what one investor may perceive as a risky strategy, another may perceive as being a hedge, depending on each investor's circumstances, other investment holdings, view, forecast of future events, and/or perception of market conditions.

Investors may employ hedging strategies and tools to reduce risk, or even "immunize" their investment holdings in stocks, bonds and other debt instruments, commodities, futures, and other investments against almost any conceivable risk, including market risk, sector or industry risk, company or business-specific risk, purchasing power risk, currency risk, interest rate risk, country-specific risk, reinvestment risk, liquidity risk, callability risk, default or credit risk, selection risk, management or agency risk, etc.

The scope of these hedging strategies and tools ranges from those employed at the portfolio level to the asset-class, sector, or industry level, to the individual security or investment instrument level. The time frame for employing hedging strategies may range from same-day or overnight to years.

Hedging strategies are sometimes employed for special or unusual circumstances, such as to protect the current value of stock subject to restrictions on sale from a decrease in value before the restriction expires. Some institutional investors adopt computer-aided hedging strategies, called "portfolio insurance" techniques, as part of an ongoing portfolio policy and objective to assure at least a minimum portfolio return in both up and down markets and from year to year. The same tools and strategies used for conservative hedging purposes are also employed--many argue aggressively, or even speculatively, rather than defensively--by "hedge funds" that attempt to capitalize on what their managers see as market imperfections or as opportunities to beat the market using market timing or business cycle sector-rotation techniques.

Hedging involves "tools" (certain investment instruments) and "techniques" (strategies). In the techniques or strategies area, first and foremost are the fundamental principles of sound investing--diversification and asset allocation. Investors can usually eliminate nearly all of the company-specific risk of stocks, the security-specific risk of individual investment instruments, selection risk, and country-specific risk by diversifying and investing in a large number of securities within a given asset class, sector, or industry, and across a number of countries. This reduces the amount invested in any particular aspect of the portfolio, and, accordingly, the potential loss that might be experienced in proportion to the total portfolio.

Similarly, investors can further reduce their exposure to loss within a given asset class, sector, or industry by allocating portions of their portfolio among different assets or asset classes whose returns are not highly correlated (or are even inversely correlated) with each other. This reduces the odds that several aspects of the portfolio might experience declines at once (and in fact may increase the odds that one element is increasing while another is experiencing losses). In general, investors should consider allocating their investments among domestic and foreign stocks, short-, intermediate-, and long-term bonds and other debt instruments, real estate, commodities, etc. and the subclasses within each larger asset class to minimize these types of risks

Many of the "tools" involved in hedging are "derivative" securities, such as options contracts, forward and futures contracts, and other derivatives that are essentially just variations or combinations of regular options and forward or futures contracts. How these tools are used to accomplish hedging objectives involves concepts that are discussed in more detail below in the section entitled, "HOW IS IT DONE?"

WHEN IS THE USE OF SUCH DEVICES INDICATED?

Because hedging tools and techniques are virtually unlimited in choices and flexibility, the situations in which hedging might be involved also become nearly limitless. But some of the more popular or frequent situations where hedging tools and techniques might be indicated include:

1. Investors want to protect current security values from price decline when they must make quick decisions with limited information. In many situations, investors can protect portfolio appreciation by using measured and well-reasoned strategies and fundamental portfolio and investment management techniques after a thorough examination of all relevant facts. Yet, large declines in value too often occur when investors do not have adequate time to fully digest the reliable information and to sort through the rumors and untruths, while waiting for the release of the true facts. While non-taxable accounts can sell without concern over taxes, hedging strategies may provide investors holding highly appreciated positions with security against loss until they have the time they need to evaluate all relevant information and then later decide whether to hold the security (with no taxable sale), or to sell (and incur the applicable taxes).

2. An investor is uncomfortable with a large percentage of value in a single stock--that is, a concentrated portfolio--but does not wish to sell and trigger capital gains taxes at the present time.

3. An investor has a large holding that is facing an almost certain dramatic movement up or down, but the question is which? For instance, the stock of a company facing a major litigation will almost certainly decline dramatically if the company loses the suit and increase significantly if it wins the suit. Investors can set up hedges that will protect them from serious loss (or even protect gains) regardless of the outcome of the suit.

4. An investor may own a large position in a stock that has trading restrictions due to initial public offering (IPO) lock-up provisions, or trading restrictions imposed by the government or the company due to insider status or other factors.

Hedging may allow this investor to control the risk of loss in a position that may have substantial value now, but may not when it is allowed to be sold.

5. An individual with a short life expectancy due to advanced age or illness (or as spousal beneficiary of a marital trust) may wish to protect against a decrease in stock or equity portfolio value (to protect the value of the assets for heirs), but may not wish to sell because the appreciated positions would receive a step-up in basis at death (but would incur substantial capital gains taxes if sold before death).

6. An individual may be in need of liquidity for a new home purchase, payments to creditors, or other cash flow needs, but does not wish to trigger capital gains taxes. By entering into a hedge strategy, the minimum value of the appreciated position can be fixed, providing an asset that can serve as collateral for loans.

7. Investment advisers, trust officers, investment managers, or other fiduciaries responsible for other people's money want to meet their fiduciary duty to protect the value of the total portfolio--this can be facilitated by diversifying and hedging against declines in value of their clients' investments. The duty to diversify and hedge appreciated or concentrated holdings (and the duty to recommend diversification and hedging) is not the focus of this chapter. But recent cases provide an excellent fact pattern for an overview of the claims that can arise in the area of the financial adviser's duty to diversify or recommend hedging strategies.

In the Levy case (2), which does not involve a testamentary trust or the Prudent Investor Rule being adopted by many states, the plaintiff received stock in Corning Inc. through a stock merger with his privately owned company. The Corning stock represented $8 million in value but was restricted from sale for one year. The plaintiff, on several occasions, made it very clear to the defendant--an investment adviser and trust company--that he wanted his Corning stock to be protected from a decline in value during the restriction period, if possible. The defendant held itself out to the public and to the plaintiff as having sophisticated wealth management and financial planning expertise. The plaintiff alleged that the defendant said that hedging the downside risk of the restricted stock was not possible. The plaintiff later learned from another investment firm that hedging the restricted stock was possible and the plaintiff then implemented a hedging strategy (using a combination of put options and call options to provide a floor and ceiling value on the stock) with another investment firm. But he took this action only after suffering losses in Corning stock prior to the time the new hedge was in place. The case settled before trial.

While the Levy case involved an investment adviser's duty to hedge, the investment advisory firm held itself out as a broader wealth management firm that provided financial planning counsel and services. Therefore, Levy is good food for thought for all financial planners and investment advisers.

Not only is the duty to diversify a necessary standard to evaluate, but there is also a growing persuasion that, in making the diversification decision, advisers must consider all reasonable methods of diversification and risk reduction. As fiduciary expert George Crawford says, "This tool [hedging strategies] is now so widely used that it should be in every fiduciary's tool kit, even if used only carefully and sparingly. Like any other tool, it can be used, or misused." (3)

HOW IS IT DONE?

Fundamental Investment Principles

Although not traditionally considered a "hedging" strategy, per se, simply employing the sound investment fundamentals of diversification and asset allocation, whenever possible, is the best way for investors to reduce the risk of their investments. Although any individual company's stock value and price volatility is related to both industry and overall market factors, the single biggest contributor to an individual stock's price volatility is its individual business risk. Overall market and industry factors may explain 20 to 40% of a typical firm's price volatility, but the remaining 60 to 80% is generally attributable to factors unique to the company. A company's business risk is unsystematic risk that investors can eliminate by diversifying into many companies rather than just one or a few. On the average, the losses sustained on the stocks of companies that (unexpectedly) perform poorly for their own peculiar reasons will be offset by comparable gains on the stocks of other companies that (unexpectedly) perform well for their own unique reasons. By diversifying into a number of companies, investors will earn the average return for the group, but with considerably less average return volatility than that associated with any single company within the group. In fact, the greater the extent that these assets are non-correlated (or inversely correlated), the better the odds that multiple positions will not experience declines simultaneously. The same basic ideas and rules apply to bonds, commodities, futures, real estate, and other investment assets and asset classes.

Even broad diversification within a sector, industry, or asset class still exposes investors to sector, industry, or asset-class risk factors as well as market-wide risk factors--what are called systematic risk factors. But investors can manage the level of their exposure to systematic risk factors by diversifying across sector, industry, or asset classes--the process of asset allocation and portfolio management. Different sectors, industries, and asset classes tend to respond differently to changing economic conditions, periods in the business cycle, and various economic, social, political, and other major events. In other words, the values of investments associated with different asset classes are imperfectly correlated. Using the principles of asset allocation and portfolio management, investors can diversify across asset classes to minimize the risk in their portfolios from individual sector, industry, and asset class risks and to derive an overall portfolio exposure to market-wide risk and volatility that is consistent with their risk tolerance and risk and return objectives. When investors can fully employ these fundamental investment principles, the need to hedge investments in any particular security, group of securities, industry, or asset class becomes negligible

and the cost to engage in such hedges is generally prohibitive, relative to the minimal benefits potentially gained. (4)

But in some cases investors cannot or do not wish to fully exploit these fundamental investment principles. At any given time, for whatever reasons, investors might have a "concentrated portfolio" (a portfolio that is over-invested in a particular security or asset class and, therefore, overexposed to risks associated with that investment) that they cannot (e.g., trading restrictions) or choose not (e.g., expectations about positive future performance) to "fix" using the fundamental principles of investment and portfolio management--these investors should consider hedging strategies.

For instance, the principal investment of the owner of a small closely held import-export business dealing principally with just two foreign countries is his closely held business. Generally, such people will be grossly under-diversified and therefore exposed to business, industry, foreign currency, and country-specific risk factors that they cannot easily diversify away or mitigate through diversification and asset allocation. But such a person may be able to engage in hedging operations both outside and inside of his business to hedge his business, industry, currency, and country risks.

Here is a real-world example. In 1996, MFS (a telecom company) was acquired by WorldCom in a $12 billion all-stock, tax-free merger. David McCourt, who was CEO of RCN, a publicly traded cable/telephone company, was a large investor in MFS and sat on the MFS board of directors. Before hedging his stock in the new MFS WorldCom, his 812,000 shares were valued at roughly $25 million. McCourt was acquainted with the management of WorldCom but did not know it well enough to place a substantial portion of his net worth at risk, which would be dependent on their success in running WorldCom. As a previously cited investment company president has put it in facing the same situation, "Today we have all our eggs in one basket, but we own the basket; if we take your stock, we'd still be all in one basket, but you'd own the basket, and that's an enormous difference!" (5)

McCourt had a similar view. "I wanted to protect my holding because when you sell something for stock, and you don't know the people, it's a smart way to manage the investment." (6)

McCourt protected his $25 million position in MFS WorldCom by entering into a "cashless collar" (also called a zero-premium collar, described below). McCourt sold call options, which could obligate him to sell his 812,308 shares at $64 a share, giving up any appreciation above that price for a period of five years from the option date of June 19, 1997. McCourt used the funds received from that transaction to purchase put options that gave him the right, for five years, to sell his shares at $28 a share, protecting himself from a decline in the share price below $28. (7)

Therefore, McCourt's investment could fluctuate between $28 and $64 a share for five years, but no more or less. If the price rose above $64, he could be obligated to sell the shares at that price and if the price fell below $28 he would be permitted to sell the shares at that price. In total value terms, his $25 million in MFS WorldCom could fluctuate between $22.75 million and $52 million in value. He guaranteed the protection of 91% of his $25 million investment (minimum value of $22.75 million), while reserving the right to achieve just over 100% appreciation on his investment, but no more ($52 million), for a five-year period.

As it happened, WorldCom appreciated nearly 300% after McCourt implemented the collar strategy. If the call option had been exercised, McCourt would have been entitled to $52 million.

But as of June 2002, the stock had declined substantially. It was worth less than 10% ($2.5 million) of the original $25 million in value as compared with the floor of the collar, which was 91% ($22.75 million) of the original $25 million in value. The hedge appears to have been a very smart play for McCourt, as evidenced by the dramatic decline in WorldCom stock the last few years. [But note this trade-off: if the hedge had not been in place and McCourt had timed the sale of his stock right, McCourt could have sold his stock for nearly 300% of the original $25 million.]
Value of WorldCom stock with hedge:   $22.75 million

6/2002 Value of WorldCom stock        $2.50 million
without hedge:                        ($2 a share)

Value Protected by hedging strategy   $20.25 million


In a bit of irony, McCourt went on to say that, if he had known WorldCom management at the time of his hedge as well as he knew them a few months later, he would never have used options to protect his investment. Fortunately for McCourt, he did not know them well and placed the hedge. While WorldCom stock had a very strong performance in the bull market up through 1999, making the option hedge look like a bad bet, the stock plummeted in 2000, 2001, and 2002, making his hedge quite valuable.

McCourt's position in MFS WorldCom was a concentrated holding, which likely represented a majority of McCourt's net worth. But just because an appreciated holding does not represent a majority of value does not mean it might not be worth hedging or protecting. Sometimes hedging will depend on an investor's ability to accept long-term declines in value in relation to the investor's anticipated goals and cash flow or liquidity needs in the future.

Example: Some institutional portfolios, trust funds, college endowment funds, charitable foundation funds, and others employ hedging strategies called "portfolio insurance" techniques to set floors or minimums on the amount the funds earn over any given period. These funds typically have reasonably predictable required outlays and want to assure that they can meet these obligations without eating into the principal of the funds. They are willing to forego some upside earnings potential in order to prevent losses below some specified level. Although they generally employ the fundamentals of modern investment, asset allocation, and portfolio theory to structure their "base" portfolios, they will use options and futures contracts and options contracts on futures contracts on broad-based market and asset-class indexes and other strategies to hedge against declines in value below their designated limit.

Also, in less volatile markets, investors generally can rebalance their portfolios periodically and incrementally with an eye towards minimizing the tax consequences and transactions costs of rebalancing by matching recognition of gains and losses while not deviating too substantially from their preferred risk/ return profile. But in more volatile markets, investors' portfolios may quickly deviate from their preferred mix among asset classes and expose them to market and asset-class risk levels that they deem unacceptable. Making adjustments all at once to move back to their preferred asset mix and risk/return profile may be difficult and expensive as well as disadvantageous for tax purposes. Sales of assets in those asset classes that have appreciated substantially and where the investor is overexposed may result in large realizations of gains (and a subsequent tax bill) that the investor may not be able to easily offset with sales of loss assets without also incurring substantial transactions costs. In such cases, the investors can enter into temporary hedging positions in options and/or financial futures that are long positions in those asset classes that are underweighted in their portfolios and short positions in those asset classes that are overweighted in their portfolios and buy time to make tax-and-cost-efficient transactions in the underlying securities to rebalance to their preferred asset mix.

So even when investors employ the fundamentals of modern investment and portfolio theory to construct a risk/return profile that meets their objectives, at times, they may still wish or need to engage in hedging operations.

Sales, Stop-Loss Orders, and Short Sales

In many cases, simply closing out or selling a position is the best decision when an investor finds it necessary to diversify a security or asset class. Often investors can also sell loss assets in their portfolio to offset gains and neutralize the tax effects. But investors overexposed in a security or asset class cannot always be sure that they will recognize the need to rebalance or that they will have sufficient time to "manage" the sale of the position and offsetting loss positions before the appreciated position declines in value. In addition, after the unprecedented gains of the 1990s, even with the market declines of the past few years, many investors are still sitting on substantially appreciated positions where it is often difficult to find offsetting loss positions within their portfolios.

Two relatively simple techniques that investors have to protect themselves from loss in these situations are stop-loss orders and short sales.

Stop-Loss Orders

Stop-loss orders are generally good-till-cancelled or standing orders with brokers to sell (or buy) a security held long (short) if the price moves below (above) a specified value. For instance, if an investor owns (is short) a stock currently worth $100, he could place a stop-loss order with his broker to sell (buy) the stock if it falls (rises) to $90 ($110). In most (but not all) cases, the investor can rest assured that if the price moves adversely, he will lose only about $10.

But the problems with stop-loss orders are three-fold. First, and this is relatively minor, but important nonetheless, the investor has to or should reassess and reset the stop-loss orders as the value of the position changes. For instance, if the investor owns the stock with a market price of $100 and a stop-loss of $90, and the market price moves to $110, he should consider resetting the stop-loss order (e.g., at $100) to protect the increased gain.

Second, and this is an important consideration in most cases, the broker will actually sell the position if the market price hits the stop-loss price. Therefore, the investor will be liable for tax on any gains realized. In many cases, investors wish to hedge against losses without realizing gains and paying tax--if that is the case, stop-loss orders are generally not a viable choice of strategy.

Third and, perhaps, most importantly, investors have no assurance that trades triggered by their stop-loss orders will take place at a price that is anywhere close to their stop-loss trigger price. For instance, in the great crash of October 1987, many investors who had stop-loss orders in place discovered, much to their chagrin, that their trades had taken place at prices 10, 20, or 30% or more below their stop-loss price. In such volatile market situations, the stop-loss orders enter the queue for trades with all the other market orders and may not be executed until the market price has declined far below the stop-loss price. In such markets, large transactions by large institutional investors frequently precipitate or foreshadow the decline in value. If they place their market orders before the security hits an investor's stop-loss price, the market price may move right through (or "gap" through) the stop-loss price before the institutions' and other investors' transactions are cleared, leaving the trades for investors with stop-loss orders to take place after much of the market move (and investment loss) has already occurred. (8)

Short Sales

A short-sale strategy involves selling securities borrowed from a third party. In general, the investor's broker or custodian arranges to borrow the securities from the margin account of one of its other customers. While short-sellers maintain their short position, they must reimburse the lenders for any dividends or interest paid on the borrowed securities. (9) If the securities decline in value, the short-seller may then purchase the securities on the open market at a lower price than the initial sales price. The short-seller returns the purchased stock to the third party and pays tax on the gain (difference between the initial sales price and subsequent purchase price) at long-term or short-term capital gain tax rates, depending on the holding period. If the short-seller closes out the short position by buying the securities after they have appreciated in value, the loss is treated as long-term or short-term capital loss.

Short Sales Against the Box

Investors use short sales for hedging purposes when they sell short "against the box." This means that they sell short securities that they also hold long in their portfolio. This technique offers perfect inverse correlation because gains or losses on the long position are perfectly matched by losses or gains on the short position. As long as an investor maintains both the long and short position, the economic value of the investor's position cannot change. The investor is perfectly immunized against loss on the long position, but also foregoes any possibility of further gain while the short against the box is in place.

Originally, this strategy was used primarily for tax timing purposes. An investor that had an appreciated position that he wanted to sell but didn't want to incur a taxable gain for could enter into a short sale against the box. This allowed the investor to perfectly hedge and thus completely avoid any further price changes (equivalent to the situation if the position had been sold outright and the investor simply no longer owned the security) without requiring the investor to declare the taxable gain (because the position was still open). Ultimately, the investor could opt to close out the position at some future point of his choosing. Doing this allowed the investor to defer the tax bill until the position was closed, possibly shift the income to a year that would be more favorable in light of tax laws or other taxable events, but eliminate all risk in the meantime (as though the position had been sold). Unfortunately, short sales against the box now are treated for income tax purposes as constructive sales, making them much less attractive for hedging purposes. Although investors can still use this technique to prevent economic loss on an appreciated position indefinitely, they generally will have to realize their gain and pay tax on the appreciated long position in the tax year in which they enter into the short sale against the box. Investors step-up the basis of their long position by the amount of the realized gain and start a new holding period for the long position, just as if they had actually sold and then repurchased the securities. If they later close out the short position by delivering the securities they hold long, losses and gains on the long and short positions will cancel out, so they will incur no further taxable consequences. But if they later close out the short position by purchasing new securities in the market for delivery, rather than by delivering the securities they hold long, they will recognize long-term or short-term gain or loss on the short position, depending upon the holding period of the short position. (See the discussion of the constructive sale rules under "What Are the Tax Implications?" below.)

Short Sales of Close Substitutes

In light of the currently unfavorable constructive sale rules for short selling against the box, an investor can, alternatively, select a short sale involving securities of a company in the same industry, which has a close, but not perfect, correlation to the securities the investor wants to protect. In general, even if closely correlated, short sales of a different company's securities will not be treated as a constructive sale. (10) For example, an investor who has a very significant holding in Dell Computer might sell short a similar amount of Gateway Computer. But as discussed above, the individual business risk is generally greater than the industry or market risk. So, any time correlation is not perfect, a hedging strategy can fail. Gateway's stock could soar while Dell's stock plummets, putting the investor in double jeopardy. Simply stated, investors cannot use short-selling strategies to hedge perfectly against company-specific events such as fraud or massive liability, unless they short that specific company's securities.

Short Sale of Exchange-Traded Funds

The strategies described above allow investors to avoid company-specific risk (on at least one side of the position). In recent years, the markets have introduced exchange-traded index funds (ETFs) that permit investors to buy long or sell short certain baskets of stocks (such as the basket of stocks that comprise an index like the S&P 500 or NASDAQ 100). This can provide investors with a more broadly diversified correlation (or inverse correlation) for market and industry or asset class risks. For example, the investor mentioned in the previous section could sell short the S&P Computer Technology sector to hedge against his position in Dell. This would not protect him from the company-specific risks for Dell, but it would eliminate most of the company-specific risks of Gateway and ensure perhaps better protection from the sector risks of Dell, as compared to when Gateway was used for the short side of the position.

Selling a Forward Contract or Futures Contract

A forward contract is a contract negotiated privately or traded over-the-counter to deliver a security at a specific time in the future, at a specific price. Also, with the recent advent of single-stock listed futures contracts on an ever-increasing number of companies, investors can now sell standardized futures contracts on many companies. Since these futures and forward contracts are substantially identical property, the use of this hedging strategy will trigger the constructive sale rules. (See the discussion of the constructive sale rules under "What Are the Tax Implications?" below.)

Example: Adams owns 1,000 shares of Z stock, currently valued at $100 per share. He contracts with Burrows to deliver 1,000 shares of Z stock, at $101 per share in three months.

Offsetting Notional Principal Contract or Equity Swap

An offsetting notional principal contract is one where the holder of a security or bundle of securities agrees to pay substantially all of the investment yield (interest, dividends, etc.) and appreciation from the security or the bundle of securities for a specified period. Generally, in return, the investor receives interest based upon an interest rate index, such as the LIBOR rate, or a bond index, such as the 20-year U.S. Treasury bond index. In addition, the investor generally is also reimbursed for substantially any loss of value in the security or bundle of securities. This arrangement should run afoul of the constructive sale rules, since it is essentially equivalent to the sale of the stock at its current price and the purchase of the bond index.

Example: Johnson owns 1,000 shares of XYZ stock, valued at $100 per share. She contracts with Masters as follows: Any dividends on the stock and any appreciation in value will be delivered to Masters. In return, Masters will pay Johnson interest on $100,000 based upon the LIBOR rate and will reimburse Johnson for any drop in the value of XYZ stock value below $100 per share.

Pre-Paid Forward Sale

A pre-paid forward sale is a risk management strategy suitable for investors whose primary goal is to monetize a concentrated equity position without incurring an immediate tax liability. The pre-paid forward sale may be appropriate for investors who have legal restrictions or practical limitations on selling their stock (e.g., restricted or unregistered stock, or stock with a low cost basis).

Investors may receive an up-front payment of 75% to 95% of the value of their stock rather than the traditional payment for the full contract amount at the time the contract matures. Generally, the investor making the forward sale has no obligations to the counterparty until the expiration of the transaction. The amount of the up-front payment may be affected by several factors, including the term of the transaction (generally, more discount of the upfront payment with longer terms), the level of an investment's upside potential (less discount or even a premium if the upside potential is substantial), prevailing interest rates (more discount with higher interest rates), and other market conditions. Essentially, this is a variation of the equity swap, since the investor selling the stock in the forward sale effectively transfers all potential appreciation or loss on the stock (payable at the end of the contract term when the stock is transferred) for the interest or other investment income or returns he will earn by investing the up-front payment.

Final Note

What these hedging techniques have in common is that the owner of the securities continues to hold the securities. All, or most, risk of loss--and opportunity for gain--on the securities is transferred from the owner to someone else. The owner has effectively disposed of the securities, while retaining nominal ownership. They also have the unfortunate consequence (generally) of triggering the constructive sale rules (but see the section entitled, "What Are the Tax Implications?" for a discussion of one method to circumvent the constructive sale rules in certain circumstances).

Options, Futures, and Other Derivatives

Given the limitations, risks, and adverse tax consequences (under the constructive sale rules) of stop-loss orders, short sales, and other essentially short-sale equivalents, many investors have turned to options, futures, and other derivative instruments to achieve their hedging objectives. To understand why, one must understand derivative instruments and markets.

Derivatives are so named because they "derive" their value in reference to the value of some other security or property. These instruments do not represent an ownership interest in the security or property. Rather, they provide investors with the right or obligation to buy or sell securities or property or to receive payments based upon the performance of some underlying security or property some time in the future. The number of new derivative instruments being introduced into the markets and the growth in the volume of trading in these markets has been tremendous. This almost revolutionary evolution provides investors with an ever-increasing arsenal for hedging an ever-expanding list of risks. The prevalence and usefulness of these instruments in hedging operations, as well as the risks associated with the misuse or misapplication of these instruments, makes it imperative that financial advisers and investors understand the fundamental nature of these instruments and their relation to markets. This is vital for anyone that seeks to successfully employ these tools in hedging strategies.

Nature of the Derivatives Markets

In contrast with the stock market or other markets trading ownership interests or claims on real or personal property, the derivatives markets are "zero-sum" games or markets. A zero-sum game is one in which the average gain and loss of all participants in the game is zero. For example, since 1926, the "average" investor (i.e., the average result amongst all investors) in the S&P 500 index of stocks has earned about 10.5% (compounded) per year, ignoring transactions costs. But the "average" investor in every options, futures, or other derivatives market, for however long all of these the markets have existed, by design, has earned exactly 0%, ignoring transactions costs.

The reason for the difference between the derivatives and the stock markets is that the market for stocks is, on average, a long market. That is, it represents ownership in the productive capacity of the economy, which has a positive value. So, although some investors may sell short shares of the market, the average position must represent a long position in the productive capacity of the economy. As knowledge grows, technology advances, and labor productivity improves, the entire economy grows (i.e., experiences real growth after inflation), providing more, on average, for everyone. Therefore, it is a positive-sum game.

In contrast, derivative securities do not represent, on balance, any ownership interest in anything. They are essentially side bets on economic values and, as such, have a total economic value of zero. (11) For example, suppose two farmers disagree about what the price of a bushel of wheat will be in 9 months. One thinks it will be less than $3, while the other thinks it will be more than $3. The one who thinks it will be less than $3 says he is willing to put his money where his mouth is and bet that it will be less than $3. He proposes that they agree today that he must sell, and the other farmer must buy, 500 bushels of his wheat in 9 months for $3 per bushel (which would be higher than he expects the price to actually be, producing a "profit" for him). The other farmer takes him up on his bet. If the farmer proposing the bet is right and the price of wheat is less than $3 per bushel in 9 months, he wins the bet and pockets the difference between the market price (less than $3) and the $3 target price of the bet.

Their bet neither creates nor destroys any wheat. It does not have any effect on the price of wheat whatsoever. (12) If the price of wheat rises above $3 per bushel, say to $4, the farmer who wins the bet and buys the 500 bushels for $3 will realize a quick $500 gain ($1 per bushel times 500 bushels) when he turns around and sells the wheat for $4. The farmer losing the bet will forfeit exactly $500 by selling the 500 bushels of wheat for $3 per bushel, when he could otherwise have sold it for $4 per bushel. Of course, they could just settle up by having the farmer losing the bet pay the winner $500 in cash. So, one farmer's gain is the other farmer's loss--the bet is a zero-sum game.

The farmers' bet is essentially a forward contract. All of the forward and futures contracts on the various commodities and financial instruments are just variations on this simple example. For every long position where someone agrees to buy a given amount of some commodity or financial instrument for a given price at a specified time in the future there must be an equal and offsetting short position where someone agrees to sell under the same terms.

Although described as zero-sum games, the derivatives markets are actually negative-sum games, since each side of every transaction pays commissions and/or other transactions costs.

If investing in these derivative instruments is a losing proposition on average, the question naturally arises as to why such markets exist and why anyone would invest in them. A good question!

The answer is risk asymmetry--different risk tolerances and capacities. Two parties can enter opposite sides of a transaction with each having the perception that the position reduces his risk. For instance, assume instead that the "bet" is between the farmer and the local baker. The farmer is willing to agree to sell the wheat in 9 months for $3 per bushel because he knows that amount will be sufficient for him to recoup his costs and still make an acceptable profit. He can rest assured that he can continue his farming the next year. Sure, he would like to sell at $4 if the price is that high, but he would gladly give up the additional $1 per bushel to insure that he still gets the $3 even if the price falls to $2. Conversely, the baker would love to buy the wheat at $2 per bushel if the price is that low, but he also would gladly pay the extra $1 to insure that he can buy the wheat at $3 per bushel even if the price rises to $4. For the farmer, the risk is that prices will fall; for the baker, that prices will rise; so they are both better off agreeing to set the price in advance to eliminate their risk. Both are willing to give up potential gains to reduce their risk.

The derivatives markets would not be nearly as immense and diverse as they are if it were not also for differences in investors' risk tolerance and capacity to bear risk. Just as some people like to bet the horses or play blackjack in Vegas, some investors are willing to speculate on the values of derivative securities, even though they are neither producers nor users of the products. In fact, the vast majority of the positions in the futures markets, for instance, are closed out prior to the expiration of the contracts by buying or selling offsetting positions. These investors provide both liquidity and depth to the markets, making them more efficient at pricing or valuing the underlying assets and the cost of risk transfer.

Therefore, basically the derivatives markets are risk transfer mechanisms. As such, they add to overall economic efficiency by reducing and transferring risks and promoting more efficient planning and production throughout the economy. Although investing in derivatives is a zero-sum game (or negative-sum game, after transactions costs), the derivatives markets as a whole add value to the economy.

Options markets, like futures markets, are also a zero-sum game (or negative-sum game after transactions costs). Similar to futures contracts, options contracts deal with the delivery of a specified amount of some financial instrument, commodity, or other property at a specified price (called the strike or exercise price) on (or before, depending on the type of contract) some specified future date. Also similar to the futures markets, for each "long" position there is an equal and opposite "short" position. The principal distinction is that options give one side of the position the right, but not the obligation, to buy or sell and the other side the obligation to sell or buy if the other side exercises his right. In futures markets, both sides of the transaction have the obligation to either buy or sell depending on whether they are "long" or "short" in the transaction (but only if the position is still "open" at the time of exercise--as mentioned above, the vast majority of futures contracts are closed out before this).

Derivatives are highly leveraged instruments. For example, on November 31, 2003, the underlying notional value of an S&P 500 A.M. index option was $1056.77. The premium for a March 2004 call with a strike price of $1,050 was $40.30 ($6.77 intrinsic value and $33.53 speculative premium). If the price of the underlying index had risen to $1,100, say, at expiration in March 2004, the call option would have been worth $50. This represents a $9.70 gain on the option above the initial $40.30 investment, or a 24% return for the 3%-month period until expiration. If an investor had paid $1,056.77 to buy the underlying index directly, the gain would have been $43.33. This represents just a 4.1% return, or about 6 times less than the return on the option, for the same period and based upon the movement of the same underlying investment.

This leverage is one feature that makes options and other derivatives such good hedging vehicles (and also such appealing speculative instruments, for those that are so inclined). The markets are generally rather liquid and investors can take offsetting positions with just pennies on the dollar relative to the securities held long. Consequently, they provide investors with a great deal of flexibility. But the leverage is inherently risky and investors may lose all of their initial investment, or more, depending upon the type of hedge and the instruments they use. Therefore, misuse of these instruments for hedging purposes can lead to severe losses, far in excess of the original risk that was meant to be hedged. A discussion of all the features and characteristics of derivatives is beyond the scope of this chapter. Readers can get further details regarding the features and characteristics of stock options, financial futures, and commodity futures in Chapters 13, 14, and 15, respectively.

Finally, the proliferation of derivative instruments stems from a desire to "span" the market and to provide vehicles capable of hedging many different types of risk in addition to potential losses in appreciated positions. For instance, one particular type of financial futures contract, the interest-rate swap, permits investors with variable interest rates on their assets and fixed interest obligations to exchange the variable interest for fixed interest. Equity swaps trade returns on an equity index for returns on another equity index or a bond or interest rate index or security. By entering into an equity swap, investors who are long on the index (or close substitutes) can essentially replace part or all of their exposure to loss on the equity position by exchanging the returns on a specified amount of the equity index for, say, interest payments tied to the 20-year Treasury bond index. Effectively, they change the composition of their portfolio and their risk/return profile without actually having to sell part or all of their position in the index. Currency futures permit investors to hedge currency risks; new swap derivatives permit investors to replace variable or fixed rate payments with inflation-adjusted payments; and the list goes on and on.

Options, Spanning, and Synthetics

The concept of spanning is important to understanding hedging and is related to the concept of creating "synthetic" securities. A market or security is "spanned" if investors can combine derivatives in that market or on that security to reproduce the risk and return characteristics of the underlying market or security. In other words, investors can create or exactly reproduce the returns on that market or security by creating "synthetic" markets or securities. When this is possible, investors can also create "synthetic" derivatives of each of the derivatives of that market or security by combining positions in the market or security together with some combination of the other derivatives in that market or on the security.

The benefit of spanning is that it makes markets more efficient, since investors will exploit price differentials in the "synthetics" relative to the underlying market or security through arbitrage and force all the instruments into price conformity. Consequently, the derivatives become even better and more reliable instruments for hedging.

To see how this works, consider the following profit profiles for two option contracts. Figures 41.1 and 41.2 show the profit profiles for call options and put options, respectively.

A profit profile shows the gain or loss an investor would realize on the option position for different prices of the underlying stock at expiration of the option. In Figures 41.1 and 41.2, the price of the stock at the initiation of the option is assumed to be $50. The exercise price of the option is also $50, or at the money. For ease of illustration, the option premium is assumed to be $10 for both the call and the put (which usually would not be the case in actuality).

[FIGURE 41.1 OMITTED]

[FIGURE 41.2 OMITTED]

If an investor buys a call option giving him the right to buy the stock, he is long in the call. If the investor writes a call, collects the premium, and is obligated to sell the stock if the buyer exercises the option, he is short in the call. Analogously, if the investor buys a put giving him the right to sell the stock, he is long in the put. If he writes a put, collects the premium, and is obligated to buy the stock if the buyer exercises the put, he is short in the put.

The long call position is equivalent to buying just the upside potential of the stock above the exercise price. For each dollar that the stock price exceeds the exercise price, the long call will increase by one dollar at expiration--perfect positive correlation. Therefore, the long call's profit profile is potentially unlimited. For each dollar the stock price falls below the exercise price, the option is worth the same amount--zero--so the investor can lose no more than the $10 premium he paid for the call. In this case, the investor will break even if the stock price rises to $60 (when the stock appreciates enough for the investor to recover the initial premium cost of the option).

If the long call is equivalent to buying the upside potential of the stock, the short call position must be equivalent to selling the upside potential of the stock. So the profit profile of the short call position shows the investor making $10 (the call premium) if the price of the stock remains below the exercise price of $50. As the price of the stock rises above $50, the short call's profit declines on a dollar-for-dollar basis with increases in the price of the underlying stock--perfect negative correlation. At $60 for the stock, the short call position just breaks even (the loss on the price appreciation perfectly matches the original premium earned when the call was written). At prices above $60 for the stock, the short call's profit profile shows ever-increasing losses. In contrast with the long call, the loss on a short call position is potentially unlimited. The gain on the short call is limited to the premium of the call option when it is written.

The profit profile of the long put position is equivalent to buying the upside gain potential of a short position in the underlying stock. In this respect it is analogous to the long call position with respect to a long position in the stock. As the price of the stock falls below the exercise price, the profit profile of the long put increases dollar-for-dollar with decreases in the price of the stock--perfect negative correlation (or perfect positive correlation with a short stock). The profit potential is limited only by the fact that the stock price cannot fall below zero. For each dollar the stock price ends up above the exercise price, the put option is worth the same amount--zero--so the investor can lose no more than his put premium of $10. The stock price has to fall to $40 for the investor to break even on the long put.

Similar to the short call, the short put position is equivalent to selling the upside gain potential of a short position in the stock. If the stock price is above the exercise price, the investor pockets the $10 premium as profit. But if the stock price falls below the exercise price, the profit profile of the short put declines dollar-for-dollar with declines in the value of the underlying stock--perfect positive correlation (or perfect negative correlation with the short stock). The investor will break even if the stock price falls to $40 and he could lose up to $40 if the stock price were to fall all the way to zero.

Figure 41.3 now shows how a combination of a long call and short put has essentially the same profit profile as the underlying stock.

Line LC + SP is derived by adding the adding the profit profiles of the long call and short put together. The gain or loss on the LC + SP position is exactly the same as the gain or loss on the stock. So holding the LC + SP position is essentially equivalent to creating a "synthetic" stock. (13) Any combination of a long call and a short put at the same exercise price, even if different than the current market price, together with a corresponding investment in the risk-free asset to keep the total investment amount equivalent, will be technically equivalent to owning the stock outright. Similarly, a combination of a short call and a long put, together with the corresponding investment in the risk-free asset, will be equivalent to a short sale of the underlying stock. This is evidenced in Figure 41.3 above by the fact that the two lines (Long Stock and LC+SP) have equivalent slopes--that is, for any particular change in the price of the stock, there is an equivalent change in the value of the investor's position, regardless of whether he holds the stock or the options.

[FIGURE 41.3 OMITTED]

Figures 41.4 and 41.5 now show the profit profiles of combinations of the options and holdings of the underlying stock.

For reference, the profit profiles of the naked options are shown at the bottom of the graphs. Line LS + SC in Figure 4 shows the profit profile of a long position in the stock combined with a short position in the call--called a "covered call" position. Notice, that the profit profile of the long stock + short call position is exactly the same as the profit profile of the short put position shown in Figure 41.2. The LS + SC or covered call position is a synthetic short put. (14)

[FIGURE 41.4 OMITTED]

[FIGURE 41.5 OMITTED]

The SS + LC line of Figure 41.4 is a combination of a short position in the underlying stock and a long call. The profit profile of this combined position is equivalent to the profit profile of the long put position shown in Figure 41.2, so the SS + LC position is a synthetic long put.

The LS + LP line of Figure 41.5 is a combination of a long position in the underlying stock and a long put position on the stock that has a profit profile identical to that of the long call position in Figure 1. This combination is a synthetic long call position.

Finally, line SS + SP of Figure 41.5 is a combination of a short position in the stock and a short put position which has a profit profile identical to the short call position shown in Figure 41.1. The SS + SP combination is a synthetic short call position.

Obviously, these are not the only combinations of these instruments that investors can create. For instance, instead of buying an at-the-money call option, investors can buy long calls with exercise prices that are either in-or-out-of-the-money. By buying an out-of-the-money call, they purchase only some of the upside potential above the current market price of the stock, rather than all of it. Various combinations of long and short calls and long and short puts with different exercise prices can permit investors to buy or sell almost any component part of the underlying security's profit profile over a given term. In addition, investors can buy and sell long and short positions in puts and calls with different terms to expiration to buy or sell components of the underlying security's profit profile that essentially begin and end at different times in the future. The possible strategies and hedging opportunities are nearly endless, so the Option Strategies section below will discuss some of the more commonly used combinations.

Option Premiums

The amount one pays for an option is called the option's premium. The premium is composed of two elements: the intrinsic value and the speculative value. Each of these values can fluctuate over time based on many factors.

The intrinsic value of an option is simply the amount by which the option's strike price is in-the-money. For example, if an investor owns a call option with a strike price of $45 when the market price of the underlying security is $50, the intrinsic value is $5. In the case of a put option on the same stock, the intrinsic value of the put option is $5 if the strike price is $55 and the market price of the underlying security is $50. Essentially, the intrinsic value of the option is the profit that could be realized if the option was exercised immediately, and the underlying stock was sold at fair market value (disregarding the cost of the option). If the option's strike price is at- or out-of-the-money, the intrinsic value is $0. Of course, the intrinsic value changes throughout the term until the option expires, as the market price of the underlying security fluctuates. At, or just before, expiration of the option, the intrinsic value and the premium become one and the same, since the speculative value of the premium disappears.

The speculative value of the premium is a function of several variables: (1) the volatility of the price of the underlying security; (2) the length of the remaining term until the option expires; (3) the dividend payout rate and the timing of dividend payments, if any; (4) the level of the risk-free rate appropriate to the remaining term until the option expires; and (5) how far in- or out-of-the-money the strike price is.

The underlying security's price volatility is a factor because the prices of more volatile securities are more likely to move into a range where the option is in (or further in) -the-money. So, all else being equal, the speculative value for more volatile securities will be greater than that for less volatile securities. In addition, if the underlying security's volatility increases (decreases) during the term until the option expires, the speculative premium will also increase (decrease).

The longer the term until the option expires, the greater the likelihood that the option will move into (or deeper into) the money. Consequently, all else being equal, speculative value diminishes as the option approaches its expiration date.

The prices of stocks paying dividends tend to decrease by the amount of dividends paid per share when the stock goes ex-dividend. Consequently, the stock's intrinsic value will decrease by the amount of the dividend, yet the option-holder does not receive the dividend. Therefore, the speculative value for call options on stocks paying higher dividends tends to be lower than that on stocks paying low or no dividends, if all else is equal--the speculative value is less because a call option will repeatedly lose intrinsic value due to dividends, reducing the upside potential for the investor. For put options, on the other hand, the effect is just the opposite.

If the risk-free (opportunity cost) rate is lower, the present value of future potential benefits is higher. Therefore, the speculative value will be greater when interest rates are lower. Conversely, a higher risk-free rate means that the investor may have attractive gains available from risk-free options and will demand a greater return (i.e., spend less for the option via a reduced speculative premium) to compensate for the risk of the option.

Finally, the deeper an option is in- or out-of-the-money, the less likely it is that its status will change substantially (i.e., from out-of-the-money to in-the-money, or vice-versa), so the speculative value tends to diminish as the stock price moves further away from the strike price. The speculative premium approaches a value of zero asymptomatically as the stock price moves further and further from the strike price.

Generally, there are two kinds of options available for most investors: American options and European options. The difference between the two is that American options can be exercised before the expiration date, whereas European options cannot. But since option premiums always include at least some speculative value until just before they expire, investors holding American options will almost always be better off if they sell the options rather than exercise them, if they wish to close out the position before the expiration date. But the investor does need to factor in the transaction cost of selling the option in the open market, including the implications of the bid/ask spread.

Option Strategies

The discussion above described the profit profiles for long call, short call, long put, and short put positions but did not elaborate on the strategic reasons for taking these positions. The following discussion will briefly explain the strategic opportunities these positions present alone before addressing how to use them in various combinations to achieve various objectives. Keep in mind that options can be written or bought on individual securities and futures contracts, sector, industry, or asset class indexes or futures contracts, or broad-based market indexes or futures contracts--so investors can use them for speculative or risk hedging purposes at each of those levels within their portfolios. Also, listed options generally expire in less than a year, but long-term options, called LEAPS, have terms of up to 2 years and 8 months from issue (and warrants may have expiration dates of 5 to 7 years or longer). Also, options written and traded over the counter can have terms of almost any duration to which the parties to the transaction agree.

Long Call

In general, the purchase of a naked call option (15) is a bullish strategy employed when an investor thinks the market will rise significantly in the relative short term (before expiration of the option). Generally, the more bullish the investor's perspective, the higher the exercise or strike price he may want for the call. Premiums decline as the strike price rises, so bullish investors potentially can still gain considerably while putting less money at risk--or can create greater leverage by purchasing a greater quantity of lower-premium options. The profit potential is theoretically unlimited and rises as the market rises. The break-even point at expiration is the strike price plus the premium. The downside risk is limited to the premium paid and generally no margin is required.

An investor also can use long calls as an effective and flexible defensive strategy when the asset allocation mix of a portfolio diverges from a preferred position. An investor can use long calls to quickly and relatively inexpensively increase the effective portfolio weights in those asset classes that are underweighted until the investor can rebalance the portfolio with sales or purchases of the securities in the portfolio. Figure 41.1 (shown earlier) illustrates the profit profile of a long call.

Short Call

Shorting calls (i.e., writing calls) is appropriate if an investor's strategic view is relative certainty that the market will not rise and he is unsure or unconcerned about whether it will fall. Investors who are quite confident in their view should write at-the-money calls or even in-the-money calls. If they are less certain of their view, they should write out-of-the-money calls. The upside gain on the position is limited to the premium received if the market price of the underlying stock is at or below the strike price. The downside risk is unlimited (unless the short call is covered--sees "Covered Call" below). Losses on the position worsen as the market price of the stock rises. An investor, who likes the idea of the strategy, but not the potentially unlimited downside risk, might be interested in a bear spread (described below). Since this is a short position, margin is always required to assure performance in the event the option is exercised. Figure 41.1 (shown earlier) illustrates the profit profile of a short call.

Long Put

Investors with a bearish perspective on market conditions for the underlying asset and who expect the market value of the underlying asset to fall significantly over the term of the option should consider buying puts. In general, investors with more bearish perspectives should look for lower exercise prices to minimize their outlay (or increase their leverage) while still expecting sufficient price movement to make a profit on the put (in a similar manner to the bullish investor in a long call). The maximum profit potential of a long put is equal to the entire strike price of the stock less the premium paid (which would apply if the value of the stock went to $0). The break-even point at expiration is equal to the original stock price minus the premium paid. Maximum losses are limited to the premium paid (which the investor will incur if the market price of the underlying asset is equal to or above the strike price at expiration). Investing in a long put requires no margin. Figure 41.2 (shown earlier) illustrates the profit profile of a long put.

Short Put

Selling a put is a moderately bullish strategy when investors are virtually certain that the market will not go down (much, if at all), but they are unsure or unconcerned about whether it will rise. If investors are very bullish, then they should consider selling puts with strike prices that are more in-the-money to get the larger premiums. The profit potential is limited to the premium received. The breakeven point at expiration is the strike price less the premium. Margin is always required to help secure the investor's obligation to sell under the contract. Potential loss is almost unlimited (almost, since the underlying price cannot fall below zero)--the maximum loss is the strike price of the contract minus the premium received. If this basic strategy is appealing, but the potential downside risk is unacceptable, investors may prefer a bull spread (described below). Figure 41.2 (shown earlier) illustrates the profit profile of a short put.

Covered Call

A covered call is a long position in the stock combined with a short call. As described above, it has the same profit profile and characteristics as a short put. Figure 41.4 (shown earlier) illustrates the profit profile for a covered call--line LS + SC.

For most investors, this relatively neutral position is employed to increase income when they expect the market price of the underlying stock to fluctuate within a fairly narrow range over the term of the option. It tends to work best when the investor expects short-term price weakness due to company-specific factors, or industry or sector or even overall factors, but has a generally optimistic forecast in the longer term. The upside potential at expiration of the option is limited to the strike price minus the market price of the stock (when the option is purchased) plus the premium received on the sale of the call. Essentially, upside appreciation potential on the stock is sold for immediate cash. The downside potential is large--the investor is still long on the underlying stock, which can experience a decline limited only by the fact that it cannot drop below $0. But the investor will retain the premium of the written call to slightly mitigate such a loss. But the most serious potential "loss" could be the opportunity lost if the market price of the stock rises sharply. Margin is always required. (16)

Protective Put

A protective put is a long position in a stock combined with a long position in a put. If the stock and put are acquired at the same time, it is called a married put. The protective put position has the same profit profile and characteristics of a long call. Figure 41.5 (shown earlier) illustrates the profit profile at expiration of a protective call--line LS + LP.

The protective put is a strategy employed when investors hold a stock long, generally with gains, and are bearish regarding the relatively short-term prospects for the market price of the stock. The put protects the value of the stock, while not preventing the position from benefiting in the event of a market rise. The profit potential is unlimited, being the ordinary return on the stock minus the fixed premium paid for the put option. The downside risk is limited to the premium paid for the put if the stock position is entirely hedged by puts, since the gains on the puts will offset the stock losses as the market falls. No margin is required.

Bull Spread

The bull spread is a moderately bullish strategy investors may employ when they are fairly certain that the market will not fall but want to cap the risk of loss. To reduce the cost of limiting the downside risk, investors sell an offsetting position that also limits their upside potential. It is a conservative strategy for investors who think that the market is more likely to rise than to fall.

Investors may implement the bull spread in two different ways:

1. Bull Spread-Call--Investor buys an in-the-money call (typically) and sells an out-of-the-money call (typically) with strike prices roughly equally spaced below and above the current market price of the stock. More aggressive or confident investors can set the strike prices higher.

2. Bull Spread-Put--Investor buys an out-of-the-money put (typically) and sells an in-the-money put option (typically) with strike prices roughly equally spaced below and above the market price of the stock. More aggressive or confident investors can set the strike prices higher.

In these examples, the current stock price is assumed to be 50, the lower strike price is 45, and the higher strike price is 55. The profit profiles for the call-based bull spread and the put-based bull spread are nearly identical, but the initial outlay for the two positions differs considerably. The initial net premium for the call-based bull spread is $4.44; the put-based bull spread generates a net premium of -$5.27. (17) The upside potential is limited in each case. For the call-based bull spread, it is limited to the difference in the strike prices, $10, less the net initial payout for the options, $4.44, or $5.46; for the put-based bull spread, it is limited to the net initial pay-in, or $5.27. The downside risk is also limited in both cases. For the call-based bull spread, the maximum potential loss is the net initial payout, or $4.44; for the put-based bull spread, the maximum potential loss is the difference between the strike prices, $10, less the net initial pay-in, $5.27, or $4.73. In this case, the break-even stock price is approximately equal to the current stock price.

[FIGURE 41.6 OMITTED]

[FIGURE 41.7 OMITTED]

The higher the investor sets the strike prices relative to the current market price, the greater is the investor's upside potential and the lesser is the investor's maximum possible loss. But the break-even point also moves higher. For example, using the same parameters as for Figures 41.6 and 41.7, except that the strike prices are set at 55 and 65, instead of 45 and 55, the call-based bull spread and put-based bull spread profit profiles are as shown in Figures 41.8 and 41.9, respectively.

[FIGURE 41.8 OMITTED]

[FIGURE 41.9 OMITTED]

Bear Spread

The bear spread is the moderately bearish analog to the vertical bull spread. Investors may employ this strategy when they think that the market will not rise, but they want to limit their risk of loss. To reduce the cost of limiting the risk of loss, investors sell an offsetting position that also limits their potential gain. It is a conservative strategy for investors who think that the market is more likely to fall than rise.

Investors may implement the bear spread in two different ways:

1. Bear Spread-Call--Investor sells an in-the-money call (typically) and buys an out-of-the-money call (typically) with strike prices roughly equally spaced below and above the current market price of the stock. More aggressive or confident investors can set the strike prices lower.

2. Bear Spread-Put--Investor sells an out-of-the-money put (typically) and buys an in-the-money put option (typically) with strike prices roughly equally spaced below and above the market price of the stock. More aggressive or confident investors can set the strike prices lower.

In these examples, the current stock price is assumed to be 50, the lower strike price is 40, and the higher strike price is 50 (i.e., an aggressive bear spread). The profit profiles for the call-based bear spread and the put-based bear spread are nearly identical, but the initial outlay for the two positions differs considerably. The initial net premium for the call-based bear spread is -$5.83 (net amount investor receives); the put-based bear spread generates a net premium of $3.87 (net amount investors pays). The upside potential is limited in each case. For the put-based bear spread, it is limited to the difference in the strike prices, $10, less the net initial payout for the options, $3.87, or $6.13; for the call-based bear spread, it is limited to the net initial pay-in, or $5.83. The downside risk is also limited in both cases. For the put-based bear spread, the maximum potential loss is the net initial payout, or $3.87; for the call-based bear spread, the maximum potential loss is the difference between the strike prices, $10, less the net initial pay-in, $5.83, or $4.17. In this case, the break-even stock price is approximately equal to $46.

[FIGURE 41.10 OMITTED]

[FIGURE 41.11 OMITTED]

Collar

A collar is a hedging strategy whereby an investor who wishes to minimize potential loss in the value of a long equity position sells an out-of-the-money covered call option and uses the premium received to reduce or offset the cost of an out-of-the-money put option, thus limiting the investor's downside risk. But the downside protection comes at the expense of foregoing some potential upside gains. The maturity of a collar can range from several months to several years, and both options may (or may not) mature simultaneously. If the call option is written in the OTC market, the investor can negotiate the strike price and premium so that the investor's out-of-pocket cost for the put and call options is reduced to zero--a zero-premium collar. In many cases, investors can pick out-of-the-money puts and calls on listed options exchanges whose premiums also come close to zeroing out. Investors who have legal restrictions or practical limitations on selling their stock (e.g., restricted or unregistered stock, or stock with a low cost basis) may find collars especially useful. (18) The collar has a profit profile very similar to the vertical bull spread.

Figure 41.12 shows the profit profile of a collar where the current stock price is 50, and the strike prices on the short call and long put are 60 and 45, respectively.

Although infrequently used, investors could also create a short collar to hedge against adverse price movements when they are short in an equity position. To create a short collar that is analogous to the long collar shown in Figure 41.12, sell a call with a strike price of 45 and buy a put with a strike price of 60. The profit profile will be similar to that of a bear spread.

[FIGURE 41.12 OMITTED]

Straddle

If investors think that the market will be very volatile in the short-term or a company is facing a situation that could greatly impact the stock price, either up or down, such as a ruling in a major lawsuit or the awarding of a major government contract, they can buy a straddle. The long straddle position will reward them if the price moves substantially either up or down. In contrast, if investors think that the market will be less volatile, they can sell a straddle and profit if the price does not move outside of a given range.

The long straddle is created by buying a call option and a put option with the same strike price; usually, at the money. The upside potential of the long straddle is unlimited. The largest possible loss is equal to the two premiums paid for the long call and long put. The breakeven point is equal to the strike price plus or minus the sum of the long call and long put premiums (since a movement in either direction brings either the call, or the put, into the money, a straddle investor can profit with a move price in either direction beyond the boundaries of the breakeven points).

The short straddle is created by selling a call and a put for the same strike price; usually, at the money. The upside potential is limited to the sum of the two premiums received on the short call and short put. The downside risk is unlimited. The breakeven point is the strike price plus or minus the sum of the short call and short put premiums (where the investor profits as long as the stock price stays within the boundaries of the breakeven points).

Figures 41.13 and 41.14 show the profit profile of a long straddle and a short straddle, respectively, where the current stock price and both strike prices are equal to 50.

[FIGURE 41.13 OMITTED]

[FIGURE 41.14 OMITTED]

Strangle

Strangles are variations on straddles. Investors use them for the same purposes. But instead of buying or selling an at-the-money call and a put, the investor buys or sells an out-of-the-money call and put. This reduces the premium cost for the long strangle as well as the maximum possible loss (which is equal to the sum of the premiums on the long call and the long put). But it also requires the stock price to move further before the investor breaks even. Similar to the straddle, the upside potential is unlimited.

For the short strangle, the lower premiums reduce the investor's maximum potential gain, which is equal to the sum of the premiums on the short call and the short put. But the range in which the stock price can fluctuate until expiration is wider, so the investor is more likely to make some profit on the position.

Figures 41.15 and 41.16 show the profit profile for a long strangle and a short strangle when the current stock price is 50 and the strike prices on the put and call are 45 and 55, respectively.

Butterfly

Butterflies are another variation on straddles with essentially the same objectives. But they employ two additional out-of-the-money options. When investors create a long butterfly, they add an out-of-the-money short call and an out-of-the-money short put to the at-the-money long call and at-the-money long put of the long straddle to reduce the net premium paid for the position. The tradeoff is that the butterfly has a limited upside potential.

[FIGURE 41.15 OMITTED]

[FIGURE 41.16 OMITTED]

In the case of the short butterfly, investors add an out-of-the-money long call and an out-of-the-money long put to the at-the-money short call and the at-the-money short put of the short straddle to limit the downside risk. The tradeoff is that the net premium the investor receives is less and, consequently, the maximum upside is less than it would be with a straddle.

Figures 41.17 and 41.18 show the profit profiles of a long butterfly and short butterfly, respectively. In this case, the current price of the stock and the strike price on the two in-the-money options are 50. The strike prices for the out-of-the money short call and short put are 60 and 40, respectively.

[FIGURE 41.17 OMITTED]

[FIGURE 41.18 OMITTED]

Calendar Spread

Calendar spreads are also known as time spreads. The most common type of calendar spread consists of opposing positions in two options of the same type (either both puts or both calls) that have the same exercise price, but expire at different times. Investors can create a long (short) time spread position by selling (buying) a short-term call option and buying (selling) a longer-term call option. The investor of the long position would profit when the price of the underlying asset is close to the strike price of the short call at its expiration.

WHAT ARE THE TAX IMPLICATIONS?

Taxes are a key factor in evaluating how to most efficiently minimize risk in taxable portfolios. For hedging strategies, two primary rules govern taxation: (1) the constructive sale rules, and (2) the straddle rules. The constructive sale rules govern when investors initiating a hedge position have to treat the transaction as a sale of the hedged security (i.e., as a taxable event), even though no actual sale has taken place. The straddle rules govern the tax aspects of closing a hedge position, including such issues as tolling or freezing capital gain holding periods and capitalizing the carrying costs (interest expense, commissions, and the like) of the hedge strategy. For most hedging situations, a primary objective is to avoid constructive sale treatment and the requirement to recognize gain (if an actual sale has not occurred). If investors can also avoid the negative aspects of the straddle rules, then the hedging strategy can be a much more tax-efficient strategy.

Constructive Sale Rules

The 1997 Tax Reform Act provides that certain transactions attempting to neutralize future gain and/or loss in a current appreciated stock holding are treated as "constructive sales," which cause recognition of gain, if entered into after June 8, 1997. (19) A constructive sale is a transaction in which the owner of an appreciated security enters into one of the following three transactions:

* A short sale of the same or substantially identical property;

* An offsetting notional principal contract with respect to the same or substantially identical property; or

* A futures or forward contract to deliver the same or substantially identical property (20)

The term "substantially identical" is normally considered to be securities issued by the same issuer, which are commercially identical in all major aspects including dividend provisions. Normally, securities issued by two different issuers are not considered "substantially identical" unless, for example, the companies are merging, are days away from a merged close, and the common stock of each company is trading for all practical intents and purposes as the same security. (21) Correlated pricing (meaning that the prices move virtually in lock-step) in the market is the key test for securities being considered substantially identical.

Initiating a put option purchase is not a constructive sale.

An investor who purchases a put option should not have the transaction treated as a constructive sale, even if the put option is for a stock the put holder already owns. Although the Internal Revenue Service (IRS) has not issued final regulations to clarify what is and is not a constructive sale, the committee report for the applicable 1997 Tax Reform Act code provisions provides some guidance. The committee report suggests that strategies that trigger constructive sale treatment are those that eliminate nearly all potential gain and loss. (22) Out-of-the-money put options only reduce some, but not all, of the potential loss and none of the gain, so purchasing a put option on stock already owned should not trigger the constructive sale rules with respect to the stock. But, in theory, if the put option is "deep-in-the-money" when the investor initiates the hedge and, therefore, it is a close proxy for the stock itself, a purchase could trigger a constructive sale or taxable event. (23)

A short sale on stocks or indexes not otherwise owned is not a constructive sale.

A short sale of a stock or stock index that is not otherwise owned by an investor is not a constructive sale because the shorted stock is not substantially identical to securities held long in the investor's portfolio. For example, selling short Ford Motor Company (which is not otherwise owned by the investor) to hedge against a potential decline in a highly appreciated position in GM Motors is not a constructive sale resulting in tax, even though the stocks are in the same industry and their stock prices are correlated (albeit imperfectly). This technique of shorting a different, but price-correlated, stock in the same industry is beneficial for avoiding the constructive sale rules while hedging against market-wide and industry-specific risks. But it is still a considerably less effective hedge (because of the imperfect correlation) than shorting against the box, which is a perfect hedge (because of the perfect correlation), because the investor is still bearing substantial company-specific risk. GM's stock could still decline while Ford's stock remained level or rose due to business factors or circumstances unique to GM (e.g., labor problems, problems with a key component parts supplier, lawsuits, liability, a recall associated with a critical design flaw in a major product line, etc.).

Selling short a stock or stock index already owned is a constructive sale (except for a few limited exceptions for short-term short sales) that triggers tax. Therefore, selling short against the box is a wise hedging strategy generally only if the reasons for hedging the position and keeping the long stock position, rather than just selling the stocks held long, outweigh the cost of accelerating the tax. Investors might wish to consider this strategy in 2008, the last year under current tax rules the 15% maximum capital gains tax rate will apply before reverting to the 20% tax rate of prior law, so as to pay tax at the lower rate and step-up the basis in their shares, especially if they expect to sell the shares in 2009 anyway. This may also be beneficial if the investor seeks to hedge away the risk of a stock that otherwise cannot be sold because of restrictions on the particular account or shares held.

Initiating a non-abusive collar should not be a constructive sale or taxable event.

Creating collars that do not essentially freeze the value of the stock within a relatively tight range ("abusive collars") should not trigger a constructive sale of the underlying stock. Generally, collars are unlikely to be considered abusive if the term of the transaction is three years or less and the difference between the floor and ceiling price of the collar is at least 20%. (24) The Congressional committee report seems to suggest that collars that are not abusive will be grandfathered under the final regulations. (25) The IRS has not issued final regulations covering constructive sales, so investors must cautiously evaluate any hedge that attempts to control both gain and loss.

There are other exemptions from the constructive sale rule, such as short-term hedges relating to shorting the same stock, but for most situations the put option, the short sale against a similar but different stock or index, and the collar are the most often used hedging techniques that can avoid the constructive sale rules. (See Chapter 43, "Taxation of Investment Vehicles," for further discussion of the constructive sale rules.)

Avoiding Constructive Sale Treatment

Investors are required to ignore the constructive sale rules if they close the offsetting position prior to January 30th of the following tax year and they retain their original position for at least 60 days after closing the offsetting position. (26) But investors must "go bare" for that 60 days--that is, without entering into another offsetting position for that 60-day period. If they enter into an offsetting position during that 60-day period, the original constructive sale in the prior year is reinstated. (For more information about the details of this exception, see Chapter 43, "Taxation of Investment Vehicles.")

Example: On May 1 last year, an investor bought 100 shares of ABC Corporation stock for $1,000. On September 3 last year, she sold short 100 shares of ABC stock for $1,600, triggering the constructive sale rules. The investor held both of these positions until January 10 of this year. On that date, she closed the offsetting short position for $1,800 and kept the "long" position open until at least March 11 (at least 60 days). During that 60-day period, the investor did not enter into any other offsetting positions that would reduce risk of loss on the original position. Since the investor met the exceptions to the constructive sale rules, she has no constructive sale for last year. When she closes her short position on January 10, she recognizes a short-term capital loss of $200 for this tax year. Her cost basis for the long position remains at $1,000, but her holding period is now deemed to have started on January 10 of this year. (27)

Example: On May 1 last year, an investor bought 100 shares of ABC Corporation stock for $1,000. On September 3 last year, she sold short 100 shares of ABC stock for $1,600, triggering the constructive sale rules. The investor held both of these positions until January 10 of this year. On that date, she closed her offsetting short position for $1,800. But because of fluctuations in the stock, the investor sells the long position on March 1 (well before the 60-day required holding period ending March 11) for $1,500. The investor has now violated the exceptions to the constructive sale rules and she must recognize the constructive sale of the original position last year (when the constructive sale actually took place), and not in the current year, when she actually sold the stock.

Straddle Rules

Avoiding the constructive sale rules is usually a paramount tax issue when hedging. A second tax issue is whether the hedge is a straddle. While the constructive sale rules apply to transactions that attempt to lock in value within a certain range, eliminating the chance for both gain and loss, the straddle rules are broader and include most situations where a taxpayer is attempting to limit losses on an appreciated security by owning another security. If a hedge is a straddle, numerous tax implications arise with respect to closing out the hedge. The tax impact of a straddle is usually much less onerous than a constructive sale, but the straddle rules are nonetheless a very important tax factor with hedges.

Straddle Defined

The Internal Revenue Code defines a straddle as "offsetting positions with respect to personal property." (28) A taxpayer holds offsetting positions "if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding 1 or more other positions... (whether or not of the same kind)." (29) Therefore, if an investor shorts a stock or buys a put option on a stock held long, that position creates a straddle.

In evaluating if the offsetting positions meet the facts and circumstances test of "intent to substantially limit risk of loss," the Internal Revenue Code provides several tests, which, if met, result in a rebuttable presumption that a straddle exists. (30) These rebuttable presumptions assume a position is a straddle if the hedge involves the same security as the protected security, even if in substantially different form. (31) These tests also presume a straddle exists if the hedge is sold or marketed as an offsetting position (regardless of the name used). (32) But these tests require that there be an inverse relationship in valuation changes between the offsetting positions. (33) The bottom line is that straddle rules will apply to nearly any hedge that reduces the investor's potential for loss on an existing position within his portfolio.

To summarize the basic straddle rules:

A straddle occurs when an investor owns stock (or a call option on the stock) and then enters into an offsetting position such as:

* an option on such stock or substantially identical stock or

* a position with respect to substantially similar or related property (not including stock).

Property is substantially similar or related to stock when the fair market value of the offsetting position primarily reflects the performance of

* a single firm;

* the same industry; or

* the same economic factors (such as interest rates, commodity prices, a stock market index, or foreign currency rates as well as other economic factors).

* In addition, changes in the fair market value of the offsetting positions must be reasonably expected to move inversely to the market value of the position held. The price relationship does not have to be one-to-one. The prices may move as a fraction or multiple of each other. In other words, if appreciated stock is on one side of the position, then a put option on the same stock or substantially similar stock on the other side of the position is a straddle.

Absent final regulations, a straddle does not appear to exist with an offsetting position in substantially similar stock. (34)

Stock acquired before January 1, 1984, is not subject to the straddle rules. (35) For these stocks, investors can purchase puts against stock positions with identical correlation and protection, yet without adverse tax implications under either the constructive sale or straddle rules.

Many other hedge strategies have straddle implications, including selling short or buying puts on an index fund (either broad based or by sector). These strategies can offer higher correlation than hedge strategies employing short sales or puts on a different stock in the same industry as the appreciated stock.
                                                     Straddle/
                                                   Constructive
Position                     Example                   Sale?

Sell Short a Substantially   Sell Short Ford to    No/No
Similar Stock                Hedge a Position
Not Otherwise Owned          in GM

Sell Short a Stock           Sell Short GM to      Yes/Yes
Already Owned                Hedge a Position
                             in GM

Purchase of Put Option       Purchase a Put        Yes/No
on Substantially             Option on Ford to
Similar Stock to a           Hedge a Position
Position Owned               in GM

Purchase of Put Option       Purchase a Put        Yes/No
on Stock                     Option on GM to
Already Owned                Hedge a Position
                             in GM

Non-Abusive Collar           Purchase Put Option   Yes/No
on Stock Already             and Sell Call
Owned                        Option on GM to
                             Limit Values to
                             a Range


Straddle Rule Tax Implications on Closing the Straddle

If an investor is in a straddle position

* The capital gain holding periods are suspended during the time of the offsets. (36) The holding period of the hedged security remains long-term if it was long-term at the time the investor initiated the hedge; non-long-term hedged securities have their holding periods started anew when the offsetting position (i.e., straddle) is closed. The holding periods for put options or other similar offsetting positions acquired to initiate the hedge remain short-term since they are prevented from becoming long-term by the suspension effect of the straddle.

* Investors may take no current deduction for losses to the extent of any unrealized gain in the offsetting positions. (37) Therefore, losses on a straddle are deferred until unrealized gains on the offsetting position are eliminated or realized. But losses on a straddle in excess of any unrealized gains may still be taken. Any deferred losses are carried forward into the subsequent tax year.

* Investors must capitalize all carrying charges and interest expense (including margin) during the offset period (net of dividends) and add them to the basis of the long stock position. This has the effect of reducing the amount of capital gain when the investor sells the long stock position. (38)

One of the major concerns of the straddle rules are that they may convert what otherwise would have been long-term capital gain into short-term capital gain for tax purposes. For example, assume an investor owns 100 shares of XYZ corp. that he purchased 3 years ago for $50 per share. The stock is now worth $100 per share, so he has a substantial unrealized long-term capital gain. He thinks the company's prospects are good in the long run, but the stock price and the stock's P/E are at their historical highs. Consequently, he fears that the price may decline in the relative short run. If he sells the shares now, he must realize and pay tax on the long-term gain of $5,000. If instead the investor purchases a put option on the stock with an exercise price per share equal to the stock's current market price of $100, he can protect himself from any loss resulting from a downward price adjustment during the term of the hedge.

Suppose the investor purchases the option to create the hedge. The hedge is not treated as a constructive sale, but it is subject to the straddle rules. Now suppose for illustration purposes that the price of the stock falls all the way to the investor's original $50 purchase price by the time the option expires. The investor will have lost the entire $5,000 long-term gain on the stock in his portfolio, but gained $5,000 on the put (less the cost of the put, of course). Now if he closes out the put by either selling the put or buying new shares in the market at $50 to deliver on the put contract for $100 per share, the $5,000 gain (less the cost of the put) will be short-term. Consequently, as a result of the transaction, he would have hedged his economic position (less the cost of the put), but converted what otherwise would have been a long-term gain taxable at the lower capital gains rate into a short-term capital gain taxable at his ordinary income tax rate (assuming he has realized no other offsetting losses in his portfolio).

Of course, he could and generally should avoid this short-term capital gain treatment by delivering the stock he held in his portfolio to satisfy the put. Since the stock delivered in this case would have a long-term holding period, the gain would be taxed as long-term gain. As a result, he would end up having exactly the same amount of money after tax as he otherwise would have had if had he originally sold the stock rather than create the hedge, but less the cost of creating the hedge.

Actually, had he originally sold the stock and then reinvested the after-tax proceeds elsewhere, for instance, at worst in a risk-free asset like T-bills, he would also have the additional after-tax interest income from the T-bills. So the hedge has cost the investor, at a minimum, the amount he paid to buy the put and create the hedge (plus commissions and other transaction costs) plus the after-tax income he could have earned by investing in a risk-free asset.

This example demonstrates two important points. First, investors must carefully assess the tax consequences of hedges that are treated as straddles and how they close out their straddle positions in light of their overall tax situation and objectives. Second, hedges are not free lunches. Hedges have both direct costs and indirect (opportunity) costs that investors must weigh relative to the benefits or objectives they hope to achieve by entering into the hedge transaction.

Economics of Primary Hedging Strategies

After the tax analysis is completed, the basic question is whether the economics merit a hedging strategy considering all relevant taxes (including estate taxes) and the variety of potential price changes for the security or portfolio to be hedged. Several possible outcomes should be modeled, using various rates of appreciation (and potential depreciation) and considering taxation and other economic impacts such as lost opportunities for other investments, dividend income, and transaction costs.

Conclusion

The decision-making process for diversification and risk management of highly appreciated securities and portfolios is becoming more prevalent and more complex. While the sale decision is usually simplest, investors and investment advisors should evaluate the alternatives, including hedging strategies for possible use. Hedging strategies can be utilized to effectively manage risk, with favorable (or at least potentially avoiding unfavorable) tax treatment. In the limited situations where hedging strategies are appropriate, the same diligent attention that is given to evaluation and implementation of hedges must be given to proper management and monitoring of hedges.

WHERE CAN I FIND OUT MORE?

The American Stock Exchange, L.L.C.

A Subsidiary of the NASDAQ-AMEX Market

An NASD Company

86 Trinity Place

New York, NY 10006 USA

1-800-THE-AMEX

(212) 306-1000

www.amex.com

Chicago Board Options Exchange, Inc.

400 South LaSalle Street

Chicago, IL 60605 USA

1-877-THE-CBOE

(312) 786-5600

www.cboe.com

International Securities Exchange L.L.

60 Broad Street

26th Floor

New York, NY 10004 USA

(212) 943-2400

www.iseoptions.com

Pacific Exchange, Inc.

Options Marketing

301 Pine Street

San Francisco, CA 94104 USA

1-877-PCX-PCX1

(415) 393-4028

www.pacificex.com

Philadelphia Stock Exchange, Inc.

1900 Market Street

Philadelphia, PA 19103 USA

1-800-THE-PHLX

(215) 496-5404

www.phlx.com

The Options Clearing Corporation

One North Wacker Drive

Chicago, IL 60606 USA

1-800-537-4258

(312) 322-6200

www.optionsclearing.com

The Options Industry Council

1-888-OPTIONS

www.888options.com

High-net-worth Investors and Listed Options, Chicago Board Options Exchange

www.ffstudies.org--Foundation for Financial Studies

www.twenty-first.com--Twenty-First Securities Corporation (Go to the Academic Press)

www.occ.treas.gov/handbook/invmgt.pdf--Office of the Comptroller of Currency (Handbook for Investment Management).

www.occ.treas.gov/handbook/deriv.pdf--Office of the Comptroller of Currency (Handbook for Risk Management of Financial Derivatives).

CHAPTER ENDNOTES

(1.) High-net-worth Investors and Listed Options, Chicago Board Options Exchange, p. 23.

(2.) The 1997 New York case of Levy v. Bessemer is an example of the fact patterns that are becoming more prevalent (No. 97 Civ. 1785, 1997 U.S. Dist. WL 431079 (S.D.N.Y. July 30, 1997). Defendant's motion to dismiss for the plaintiff's failure to state a claim upon which relief could be granted was denied. In the original complaint by the plaintiff, claims of negligence, negligent misrepresentation, breach of fiduciary duty, breach of the duty to supervise, breach of contract, and fraud were alleged. The only claim dismissed by the court was the breach of contract claim.

(3.) Summarizing the key argument found in one of the seminal papers on a fiduciary's duty to hedge. George Crawford, "A Fiduciary Duty to Use Derivatives," 1 STAN. J.L. BUS & FIN. 307 (1995). For a complete discussion of the duty of fiduciaries to hedge, Crawford's paper is an excellent overview. See also, "A Trust Fiduciary's Duty to Implement Capital Preservation Strategies Using Financial Derivatives Techniques," Randall H. Borkus, 36 REAL PROP., PROB. & TR.J. 150 (2001).

(4.) But as the flexibility for hedging increases, tools such as index options are developing that provide investors the opportunity to hedge against even broad, systematic market risk in a way that still involves trade-offs, but may be cost-effective.

(5.) "Reflections on Portfolio Management after 25 Years," Robert W. Jeffrey, Journal of Investing, 2001.

(6.) Elizabeth MacDonald, "WorldCom Director Uses Exotic Play to Hedge Stake," The Wall Street Journal, October 15, 1997.

(7.) Due to a subsequent split in WorldCom stock, his 812,308 shares eventually increased to 1,218,462 shares.

(8.) There are technically two types of stop-loss orders--a stop-market order, and a stop-limit order. A stop-market order converts into a regular market order and executes a sale (purchase) as soon as the price of the security falls (rises) to the stop level. A stop-limit order actually utilizes two prices--a stop price, and a limit price. When the value of the security reaches the stop price, the order converts into a regular limit order, and thus will only actually execute a sale (purchase) as long as the price is above (below) the level of the limit order. For example, if a security is at $100, an investor might enter a stop-limit order with a stop of $90 and a limit of $88 (in fact, the limit price can be higher, lower, or equal to the stop price). In this case, if the security drops below the price of $90, the order will immediately become a limit order at $88. If the price moved to $90 slowly, the limit order will likely execute immediately around $90 (since this is higher than $88). But if the stock gapped down and fell precipitously from $91 to $87, the stop-limit will convert to a limit, but will not actually execute the sale until the price rises back above $88. This ensures that the investor will not sell the security at the very bottom of a short-term precipitous drop; But this also means that the underlying limit order may never be executed (if the stock continues to fall and never moves back above $88), in which case the investor will have gained no value from the protection strategy. Consequently, stop-limit orders should be used with caution, particularly if the investor is concerned about a sudden sharp decline in the stock price.

(9.) Caveat for investors with margin accounts: brokers generally may lend securities held long in their customers' margin accounts to other customers wishing to sell such securities short. They may not even notify a customer that his securities are being lent. In general, this would not pose a serious problem. If an investor wishes to sell securities that have been lent, the broker simply borrows someone else's securities and uses them to replace those that had been lent. For tax purposes, the investor is treated as if he had never lent the securities. But under current tax law, payments received in lieu of dividends that qualify for the preferential capital gains tax rate, are not treated as qualifying dividends. In other words, investors who lend stock will have the cash payments they receive in lieu of qualifying dividends taxed at their ordinary income tax rate as ordinary interest-type investment income, not at the lower rate for qualifying dividends. Brokers may have to make adjustments to their margin account agreements to account for this differential tax treatment. This may require investors who sell stock short to make in-lieu-of-dividend payments that are actually greater than the actual dividend payments to compensate the lender for the additional tax on the payments. The status of this issue is ongoing--at the time of publication, the last IRS discussion on this issue was covered in IRS Notice 2003-67.

(10.) Short sales of close substitutes also appear to avoid tax treatment as a straddle. See the discussion of the tax rules for straddles in the section entitled, "What Are the Tax Implications?"

(11.) The fact that the sum or total value of all positions in all derivatives markets is zero, does not mean that the functioning of the derivatives markets provides no value to the economy, as will be explained later.

(12.) The existence of a futures market can have an effect on the prices of the underlying commodities by making the markets more efficient and reducing risk, as will be discussed later.

(13.) Generally, the call premium for a call will be greater than the premium for a put with the same exercise price and term, so the investor will generally end up paying a net premium for the position. In addition, the position must account for the opportunity cost of funds. If the net premium for the position is actually $3, for example, the investor must add the value of an additional $47 investment in the risk-free asset (generally T-bills) to equal the $50 amount he would otherwise have to spend to buy the stock directly. The combined option position together with the T-bill investment is technically equivalent to the long stock position.

(14.) Keep in mind that, theoretically, the "synthetics" also include investments in the "risk-free" asset (i.e., T-bills) equating the outlays. Also, from a practical perspective the "synthetics" are never quite identical to the actual securities because of differences in margin requirements, tax rules, commissions and other transactions costs.

(15.) Call options are often referred to as "naked" or "covered"--the label refers to whether the investor has a corresponding open position in the underlying stock or asset. See the section entitled "Covered Call" later in this chapter.

(16.) Although margin is always required for a covered call, and IRA accounts cannot use margin, some custodians do allow an investor to write covered calls (or sometimes cash-secured calls) in an IRA account (i.e., the option writing doesn't actually utilize any margin borrowing). But doing this improperly risks disqualification of the IRA account.

(17.) The negative premium means that the investor received the net amount, rather than paid it. The position value line shows what the net premium would be for various initial prices of the stock assuming all other factors being the same. The position values are computed based upon a 9-month (270-day) term until expiration, a stock price standard deviation of 33% per year, a 4% annualized risk-free rate, and a 3% annualized dividend rate. The individual option values were estimated using Merton's continuous-dividend version of the Black-Scholes option-pricing model.

(18.) In this case, since the stock often cannot be sold because of the restriction, the investor can sell the put to recover the value of the decrease in the stock (which will reflect its intrinsic and speculative value), rather than simply exercising the put. But in the event that the stock rises, the call will be exercised against the investor--who may still be unable to sell the stock to the call option holder because of restrictions. In this case, the investor can sometimes purchase stock on the open market to immediately sell to the call holder. But this will create an instant loss as the stock is purchased at market value and sold for the (lower) strike price of the call. Alternatively, the investor could sell short the stock, but may be subject to the short-selling-against-the-box rules. Consequently, the best choice may be for the investor to purchase an offsetting call option to close out the position.

(19.) The 1997 Tax Act added IRC Section 1259, titled "Constructive Sales Treatment for Appreciated Financial Positions."

(20.) IRC Sec. 1259(c).

(21.) Treas. Reg. [section] 1.1233-1(d)(1).

(22.) Committee Report on P.L. 105-34 (Taxpayer Relief Act of 1997).

(23.) According to the Chicago Board Options Exchange (CBOE), a put option is in-the-money if the strike price is greater than the market price of the underlying security. If the put option strike price is significantly higher than the market price of the underlying stock, the put option trades somewhat like the stock itself and is considered "deep-in-the-money." Because deep-in-the-money puts correlate very closely with the price movements of the underlying stock (far more than out-of-the-money puts), there is a risk that the deep-in-the-money put could be considered substantially identical property that triggers a constructive sale. Future regulations may deem a deep-in-the-money put as an abusive hedging transaction that is not grandfathered.

(24.) This generalization may not apply if the collar is used to hedge a stock with very high volatility, so more conservative investors may wish to wait until the IRS releases regulations before relying on this guidance.

(25.) H.R. Conf. Rep. No. 105-220, at p. 514 (1997).

(26.) IRC Sec. 1259(c)(3).

(27.) IRC Sec. 1233(b)(2).

(28.) IRC Sec. 1092(c) (1).

(29.) IRC Sec. 1092(c)(2)(a).

(30.) IRC Sec. 1092(c)(3).

(31.) IRC Secs. 1092(c)(3)(A)(i), 1092(c)(3)(A)(ii).

(32.) IRC Sec. 1092(c)(3)(A)(iv).

(33.) IRC Sec. 1092(c)(3)(A).

(34.) "Stock offset by another position (other than an option) in substantially similar or related stock ... does not constitute a straddle." Joint Committee of Taxation's General Explanation of the Tax Provisions of the Deficit Reduction Act of 1984 at p. 309.

(35.) IRC Sec. 1092.

(36.) Treas. Reg. [section] 1.1092(b)-2T(a). Security positions that are long-term prior to the creation of the straddle maintain their long-term nature when the straddle is unwound.

(37.) IRC Sec. 1092(a)(1)(A).

(38.) IRC Sec. 263(g).
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Title Annotation:Techniques of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
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Geographic Code:1U2NY
Date:Jan 1, 2006
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