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Chapter 1. Put Options In Detail

Special Tax Factors Covering Put Options Transactions
In the two preceding examples, the trader exercised the buying of 90-day Put options. In the first example, he was protecting an unrealized profit of 20 points (he had bought the stock at 30 and four months later, when the stock was at 50, he bought a Put at 50). In the second option he protected himself against loss on a new commitment (he bought the stock at 50 and at the same time he bought a Put at 50). The first type of transaction brings into play a special rule of the federal income tax law; the second type of transaction brings into play an exception to that rule. The special rule states that if a taxpayer makes a short-sale of stock and (1) if at the time of making the short-sale he has held the same stock for not more than 6 months, or (2) if, while the short-sale was open, he has acquired more of the same stock, there will be two consequences:

First, any gain on closing the short-sale will be a short-term capital gain, even though the short-sale is closed by the delivery of stock that, at the time of delivery, has been held for more than 6 months.

Second, the holding period of the stock that at the time of the short-sale had been held for less than 6 months or had been acquired while the short-sale was open, starts on the day the short-sale is closed. The length of time that the stock was held before the short-sale was made and the length of time it was held while the short-sale was open are ignored.

For the purpose of applying this special rule, the acquisition of a Put is considered to be the making of a short-sale, and the exercise or the expiration of the Put is treated as the closing of a short-sale.

In the first example, the stock which had cost 30 had been held for only 4 months when the Put was bought. If the taxpayer had made a short-sale instead of buying a Put, the special rule would have become applicable.

Since the acquisition of Put options, under these circumstances, is the making of a short-sale, such acquisition made the special rule applicable. If, when a Put expires, the market is 70 and the trader sells his stock at 70 at a time which is more than 6 months after the date of the acquisition of the stock, but not more than 6 months from the date on which the Put expired, his gain will be short term, despite the fact that he has actually held the stock for more than 6 months.

If the market is 50 or under at the expiration date of the Put, and he exercises the Put by delivering the stock which he bought at 30, his gain will be short term even though at the time of the delivery his stock has been held for more than 6 months.

If, however, he did not buy the Put until after his stock had been held for more than 6 months, the special rule would not apply for the reason that the conditions that bring the rule into play would not exist; i.e., the Put was not acquired at a time when stock had been held for not more than 6 months nor was any stock purchased while the Put was in force. Consequently, any gain on the sale of the stock, whether from a sale in the market (at a price above the price in the Put) or delivery upon exercise of the Put, will be long term.

If, when the trader buys a Put on 100 shares, he has two lots of the same stock—100 shares which he has held for more than 6 months and 100 shares which he has held for not more than 6 months—a peculiar situation comes about. If the trader exercises the Put, he must be careful which lot of stock he delivers. If he delivers the lot, which has been held for more than 6 months at the time he purchased the Put, he will have a short-term gain on the exercise of the Put; and if within 6 months of exercising the Put he sells the other lot, he will have a short-term gain on the latter sale, also.

This unusual situation comes about as follows:

The purchase of Put options is treated as the making of a short-sale for the reason that, at the time of the purchase, one lot of stock has not been held for more than 6 months.

The first of the two consequences mentioned above is that any gain on the closing of a short-sale to which the special rule applies is to be treated as a short-term gain. The second consequence is that the holding period on the stock which has been held for not more than 6 months when the Put was purchased, starts on the day the short-sale was closed (i.e., the day the Put was exercised). Therefore, if the latter lot is sold within 6 months of the date of the exercise of the Put, the gain will be short term.

If the trader had exercised the Put by delivering the lot which had been held for not more than 6 months at the time of the purchase of the Put, the gain on the closing of the short-sale would still be short term but he would be left with the lot that had been held for more than 6 months; this lot would not have lost its holding period, and when it was later sold, the gain would be long-term.

Purchasing a Put Option to Maintain a Short Position

A man is "short" of 100 shares of XYZ which he sold short at 55 (he hopes to buy it back at 30)—the stock is now selling at 50. He originally deposited funds with his broker to margin this short sale but he now has use for these funds. How can he withdraw these funds from his account and still profit by a further decline of the stock? If he covers the stock that is short, he will no longer need margin for that short sale, and he can withdraw his funds. He then buys a Put option at 50 (the market) for 90 days for $350.00. If before the expiration of the Put option the stock declines to 30, he buys stock in the market at 30 and delivers it against his Put contract at 50. He has accomplished two things—he released the margin that he needed for his business or something else and through his Put contract was able to share in the further decline in the market—all with the risk limited to the cost of the option. This operation brings to mind the oft quoted adage: You can't have your cake and eat it—but in this case you can.

Buying Stock to Make a Long-Term Gain and Protecting the Commitment

An exception to the rule that the acquisition of Put options is a short sale occurs when (1) a given stock and Put are acquired on the same date, and (2) a given stock is identified as that intended to be used in exercising the Put. If these two requirements are met, the acquisition of the Put will not be treated as a short sale and the special rule will not be applicable.

In order to get a long-term gain and have protection against loss for the entire holding period, you must buy a Put good for more than 6 months and you must buy it the same day you buy the stock.

In other words, if the stock is selling at 50 and you buy 100 shares of stock at 50 and at the same time (that is, the same day) buy a Put good for over 6 months, you are allowed to carry the stock fully protected by the Put for the duration of the option (of course, the stock must be properly margined). If at the end of 6 months and a few days the stock has risen to, say, 75, you can sell out your stock, and your profit is long-term gain. In this case, the holding period of the stock is not affected by the purchase of the protective Put option.

If, on the other hand, by the expiration of the Put the stock has declined to 30, you exercise your Put at 50, and your loss is limited to the cost of your Put option plus stock-exchange commissions and taxes. In this case you have had an opportunity to make an unlimited long-term gain with a risk limited to the cost of your option and commissions. How else could you have an opportunity to make a possible unlimited profit with a small limited loss?

A Put Option vs. a "Stop-Loss" Order to Protect a Purchase

Mr. A. buys 100 shares of stock at 50 and protects the purchase by buying a 90-day Put at 50, for which he pays $350. In the first 20 days, the stock declines to 45. Mr. A. doesn't have to worry—his Put option guarantees that he can sell the stock at 50 at any time before the Put contract expires—so he waits. In the next 30 or 40 days (his Put option hasn't yet expired) the stock rises to 60, and at this price Mr. A. sells his stock. He has a profit of 10 points less $350—the cost of his Put option.

Mr. B., on the other hand, buys 100 shares at 50 and at the same time enters a "stop loss" order at 46. Such an order becomes an order to sell only if the stock sells at 46, and then it becomes an order to sell at the best price obtainable. If such an order is executed or "touched off," Mr. B. will probably get 46 or less for his stock—a loss of about $400 and he is out. His loss is greater than the cost of his choice of Put options, which Mr. A. bought, and he cannot benefit when the stock rises to 60. See the difference?

Using a Put to Make a Long-Term Gain in a Declining Market

There is no way, except for the one I shall describe, that one can make a long-term gain in a declining market. If one has a profit on a short-sale, that profit is a short-term gain regardless of how long one is "short" the stock. If, in anticipation of a decline, one sold "short" at 50 and stayed short for 6 months, or even a year, and then covered at a profit, that profit would be a short-term gain. The only way that a long-term profit can be made in a falling market is through the purchase of a Put option good for over 6 months and the sale of the contract itself after it has been held over 6 months if the decline in the stock in question is great enough to show a profit. As an example:

A taxpayer buys a Put option at 50, good for 6 months and 10 days, for $500. After he has owned the option for 6 months and a day, the stock is selling at 30. By selling the actual contract to someone (and my firm—and others as well—will always be willing to buy an option from the holder which shows him a profit, if it is in our hands 24 hours before it expires) he will be selling a contract which he has held for over 6 months and the profit will be a long-term capital gain. The option-dealer will exercise the contract for his account and will sell the corresponding stock in the market (in the case of the Call), or will buy the stock in the market (in the case of a Put). The purchase price, which the option-dealer will pay, will be equal to the net proceeds of the dealer's transactions less two regular stock exchange commissions and any applicable tax.

You can, however, very easily spoil your opportunity to make such a long-term gain by handling such a situation wrongly; then, instead of creating a long-term gain taxable at 25 percent, you might end up paying a tax of 60, 70, or 80 per cent according to your tax bracket. Suppose, instead of selling the Put contract for the difference between the Put price of 50 and the market price of 30, you bought the 100 shares of stock in the market at 30 and exercised your option at 50. Your profit would be the same as in the first operation, but your tax would be a short-term gain. The reason? Your tax is based not on the duration of the option but on the length of time you hold the stock in question, and in this case you would have held the stock and sold it through your Put option all in one day. This makes the difference between your paying a tax of 25 per cent or one of 60, 70, or 80 per cent, according to the tax bracket you are in for the put options you earn money on.

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