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Options trading: Three options-based tax planning ideas for carryover losses

By  Oct 28, 2010

Topics: Finance & Investing

After the disastrous markets of the last two years, many investors and traders find themselves with huge carryover capital losses. Under current rules, you can deduct only $3,000 maximum per year, meaning that the excess could last for many years into the future. However, this situation presents opportunities involving options. Three goods ideas are among these opportunities …

1. Write unqualified covered calls. Most advice regarding covered calls is to avoid the unqualified contracts. These are deep in-the-money calls. The tax rules state that if you write an unqualified covered call, you could lose the favorable tax treatment on the underlying stock. So what you thought as going to be a long-term gain is taxed at short-term rates. For big-dollar profits, this is a serious consequence.

However, when you have a large carryover loss, it doesn’t matter if your capital gains are taxed at short-term rates. Your capital gains are sheltered from tax as long as your carryover losses are larger. The carryover is a hidden benefit because it frees you up to execute any option strategy you want without worrying about the tax outcome.

2. Use options for short-term swing trades. Some traders avoid obvious swing trading advantages because they don‘t want to increase their short-term profits because of the added tax burden. For example, if you own stock and a positive earnings surprise makes the price shoot up many points, you know it is probably going to correct in the next two to three sessions. In this situation, you can buy puts or sell calls to set up a very fast short-term profit.

With that big carryover loss, you do not need to worry about the tax burden because there isn’t one. The short-term profit on the option play is absorbed and offset by the carryover loss. So you can enter short-term swing trades to create immediate profits, with no tax consequences.

3. Create combinations for short-term profits. Advanced strategies like short straddles, iron condors and butterfly spreads create limited but consistent profits if entered when implied volatility is high and time decay is rapid. However, a large volume of these short-term trades also add to your tax burden.

With the carryover loss, you can execute advanced trades without any added tax burden. In fact, you increase your trading advantage with tax-free options trades, created due to the carryover loss itself.

These ideas help you to absorb your carryover loss quickly, but even more beneficial, the tax-free profits you get from these options strategies make them more attractive than when they are also taxable. When you have a large carryover loss, it frees up your trading point of view because profits will not be taxed as long as you have more loss to absorb. This means it will be advantageous to also take the big gains in your stock positions that have built up over many years. As long as you avoid the 30-day wash sale restriction on repurchasing, you can use the carryover in a two-part tax strategy: First, sell the position and take the big gain. Second, wait at least 31 days and then repurchase the same shares. This sets up a new, higher basis in the shares while recognizing the big gains without any tax consequence. There is a risk that share value will appreciate during the 31 days; but a calculation of the potential loss versus the long-term tax advantage this gives you probably makes the risk acceptable.

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.