How to make a black-swan tactic fly

A look at the costs and tax consequences of using out-of-the-money options as disaster insurance

Aug 28, 2011 @ 12:01 am

Aware of the difficulty of making money in the recent/current market storm, some managers have employed black-swan financial strategies — which attempt to protect against statistically possible but highly unlikely events. According to press reports, black-swan fund managers purchased out-of-the-money puts on the stock market to create their disaster insurance. But questions emerged, namely how those successful managers actually did it and whether the insurance was worth the cost.

Let's look at the strategy.

The idea is to buy options that won't cost a lot, because of the high likelihood they will expire worthless. That leads to buying way-out-of-the-money options. But the problem is that there must be a balance between the cost of the puts and the ability for the puts to react to a big down market move. How much an option moves in relation to the underlying security is called “delta.” A delta of 30, for instance, means that if the underlying index moves one point, the option price is expected to change by 30 cents.

As options get further out of the money, the delta goes down; as the strike price gets closer to the current market price, the delta increases. Very deep-in-the-money options have a delta of 100, meaning they move 1-for-1 with the underlying index.

OUT OF THE MONEY

We see activity in put options that are 20% to 25% out of the money and four to eight months in maturity. These puts can increase dramatically in price not only because the delta increases as markets trade lower but also because the implied volatility tends to spike up, further increasing the market value of the puts.

The purchase of a put could affect the holding period of parts of an investor's portfolio. If an investor owns an S&P 500 fund, for example, and buys a put on that index, the holding period on the fund is stopped. This has no negative implications if the holding is already long-term, but it will prevent a short-term profit from becoming a long-term profit. This change in holding period is the law, even if the put that is purchased is way out of the money and gives only disaster protection.

When hedging a portfolio, there are no concerns about holding periods unless your portfolio and the index referenced in the put have a 70% or more overlap.

Taxation of the put is another issue. An option on a non-exotic ETF should be taxed like an option on a stock. If a put on an ETF is purchased and is held for less than one year, the investor is taxed at short-term rates. An option on an index itself, not the ETF following the index, is taxed differently. These are IRC Section 1256 contracts that are taxed as if 60% of the gain/loss were long-term, the other 40% short-term.

It would seem that if the investor thought the puts would expire worthless, he or she would buy puts on the ETF to get a 100% short-term loss, versus a 60% long-term loss and a 40% short-term loss. If the investor instead wanted to plan on the puts' becoming profitable, the investor would buy index puts if the holding were to be less than one year. If the bearish investor wanted 100% long-term-gain treatment, this could be accomplished by buying puts on the ETF that matured after more than one year.

Maximum tax efficiency might be achieved by purchasing put options on ETFs that mature more than 12 months out. The expectation would be to sell the puts before one year elapsed, if the puts were close to worthless, and take a short-term loss. If the puts look like they will be profitable, the investor can wait until the long-term holding period has been satisfied and then sell the puts for a long-term gain.

There are three other factors to take into consideration when engineering black-swan protection. First, IRC Section 1256 contracts are marked to market for unrealized profits/losses at year-end. ETF options are not marked to market at year-end but are taxed normally. Second, a single S&P 500 index option covers $114,000 in notional stock market value, while one SPDR ETF put option covers just $11,400 in value. Finally, the annualized cost of a one-year put could be considerably more or less than the cost of purchasing a series of shorter-term puts.

Discipline is needed in buying disaster insurance. The strategy has potential for profit only if the investor continues to buy puts as older options expire worthless and doesn't deviate from the plan.

Robert N. Gordon, who can be reached at bob@twenty-first.com, is chief executive of Twenty-First Securities Corp. and an adjunct professor at New York University's Leonard N. Stern School of Business.

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