Tax Considerations for investing in LEAP/Warrants

[RedLion]

I'm trying to make moves in my portfolio to improve tax efficiency, and trying to reduce frequent trading at least on my larger positions (I frequently maneuver in and out of starter positions as I get to learn about an industry and consolidate my positions, but usually only if I can do so without a big short term gain). I like to play around with options, just to give me something to do, and I have been profitable but usually end up paying a very high tax rate on these returns. 

 

I've been thinking of ways to use LEAPS and warrants to try to improve the tax efficiency of my portfolio. I've worked out a basic hypothesis, and wanted to see if I could get some feedback. 

 

My idea would be to go long on various positions via LEAPS and warrants when the price of leverage is attractive. I use the notional exposure of the options to match my ideal position sizing. e.g. if I want $100,000 position sizing of GOOGL then I buy 10 contracts of an in the money LEAP, I keep the rest of the money that wasn't spent on options premia sitting in T-bills.

 

It seems like there might be a few advantages to scaling into new positions this way, including risk of total loss of capital in a huge market downturn or black swan, but I'm mainly interested in the tax ramifications. 

 

So it seems to me that if one employed this approach there would really be three buckets.

 

Bucket 1) The underlying stock appreciates significantly, you're sitting on a large unrealized gain, and you see reasonable forward prospects, you can simply exercise the options as it nears expiration or otherwise makes sense to get the dividend, and defer paying capital gains tax until eventually selling the underlying. 

 

Bucket 2) And this is where it gets dicy because I don't know the options tax rules and need to learn a lot more, it seems like you could roll over losing options and extend duration out shortly before losses went long term. This way you're always keeping fairly long duration options, even when you sell them for a loss you still probably have 6 months to expiration and you roll out to 18 months, for example. Does anyone know if this strategy is disallowed? It seems like as long as you're selling a LEAP for a short term loss and then rolling over to a much longer duration option this would be kosher, but this is a wild guess. Anyway, if you continue to roll these LEAP options, hopefully they eventually migrate back to bucket 1. 

 

Bucket 3) Cut bait. Take your short term losses, and move on in search of better opportunities. 

 

 

I currently have a large position in OXY warrants, GOOGL $75 LEAPs, and just initiated CI in the money LEAPs. Also have much smaller position in some illiquid CLPR call options which are deep underwater, and look likely to generate to some short term losses whether I like it or not. I'm not in any big rush, but before making any big trading moves I plan to sit down with my CPA for a primer on the above. 

[lnofeisone]

I have a lot of thoughts here that I'll lay out later but two things I would note: 1) anytime you buy/sell options, go to your broker's tax page and make sure they are tagging your positions as single tax lots. I'll explain more on that later.  2) If you are holding LEAPs and you hold them over 12 months, your gains get treated as long term. So here is a scenario:

 

1) You buy a leap (say a call) or a warrant - Option_1 AND hold it for 12 months + 1 day -> you get long term tax rates

2) Underlying appreciates

3) You sell a call at a higher strike price than Option_1 -> this one will always be taxed at short term rate

 

So here is the trade that I've been milking for the last year:

1) I have a CVE Warrant position which I bought when CVE was around $12

2) CVE and warrants appreciated 

2) I've been selling CVE $22 calls anytime CVE touched $19.5

 

If my CVE $22 calls expire worthless, great that's my gain and I pay ST tax.

If my CVE $22 calls go against me, I take the loss on the $22 calls which is ST which I can write off immediately (this is the reason why I keep all option tax lots separate. if you don't, you end up creating what's known as a straddle (not the options kind but the IRS definition kind) which prevents you from taking short term losses until you close out the long position). You can also sell the warrants to match the losses you've taken on the $22 calls and you end up with LT tax on the warrants, ST tax on loss for the calls. 

 

When trading options, you can inadvertently create position you don't intend to. For example:

 

1) I bought CVE at $12

2) CVE went to $19

3) I bought $15 put to protect gains

4) Put expired worthless

 

You can't take the loss on the put UNTIL you sell the CVE position because you created a straddle and you have a leg with gains that you have to close out. IRS Section 550 does an OK job explaining a lot of this but they really need to update it to reflect the reality of things like publicly traded warrants, access to LEAPs by hoi poloi, etc.

 

 

 

 

 

 

[rkbabang]

Also a good thing to note is that if you buy/sell options in a IRA or 401K you don't have to worry about the taxes on the gains.