Author Topic: Hedging exposure  (Read 2332 times)

Aurelius

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Hedging exposure
« on: February 26, 2020, 05:56:11 AM »
Looking for some help hedging my long (tech) exposure, as I’m totally new to shorting/hedging. Don’t want to sell because of tax reasons. I’m on Interactive Brokers.

For example I own GOOG. If I wanted to hedge this position I should be able to sell GOOGL, right?

I own names like GOOG, FB, AMZN.
I’m thinking shorting the Nasdaq to hedge some of my exposure. How would I do that? Is there a simple way to go short the index?


gfp

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Re: Hedging exposure
« Reply #1 on: February 26, 2020, 06:46:25 AM »
I'm sure you could get more specific with ETF's but it sounds like you are looking to short the QQQ, a very liquid exchange traded fund that tracks the Nasdaq 100 index.  I would check with an advisor on the tax legitimacy of using a GOOGL short to hedge a position in GOOG.  It is possible you could get into trouble in the same account.

- look into "constructive sale" rules on substantially identical securities
« Last Edit: February 26, 2020, 06:48:32 AM by gfp »

John Hjorth

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Re: Hedging exposure
« Reply #2 on: February 26, 2020, 07:06:09 AM »
Aurelius,

If I remember correctly, you're Danish :

Kursgevinstbeskatningsloven, chapter 6 - Financial Contracts.

[In short, gains [and losses] from financial contracts are taxed separately, and not as part of your "Aktieindkomst" [Translated to English : Income from stocks]].
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LC

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Re: Hedging exposure
« Reply #3 on: February 26, 2020, 07:29:05 AM »
Selling short or buying put options on GOOGL as a way to hedge a long GOOG position would probably be considered a constructive sale (i.e. no different than if you just sold GOOG).

You should look for tech-focused ETFs that closely track GOOG, something like XLK, VGT, IYW, FTEC...
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Aurelius

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Re: Hedging exposure
« Reply #4 on: February 26, 2020, 02:52:16 PM »
Thanks all - appreciate your answers.

John Hjort:
Yes, Danish --- I really need to do more reading, but from the outset it seems shorting individual stocks is out of the question, because of tax regulations. (profits are taxed highly and losses are only deductible towards profits from other shorts)

Do you have you any experience hedging (shorting) with regards to DK tax regulation?

John Hjorth

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Re: Hedging exposure
« Reply #5 on: February 27, 2020, 02:15:42 AM »
Thanks all - appreciate your answers.

John Hjort:
Yes, Danish --- I really need to do more reading, but from the outset it seems shorting individual stocks is out of the question, because of tax regulations. (profits are taxed highly and losses are only deductible towards profits from other shorts)

Do you have you any experience hedging (shorting) with regards to DK tax regulation?

Aurelius,

You got it right : It's - as a basis - out of the question for Danish private investors [, and that's why I don't engage in it].

To elaborate a bit :

Your Danish taxable income consists of four components :

Arbejdsindkomst [<- In Danish, in English : Working income],
Kapitalindkomst [<- In Danish, in English : Capital income],
Ligningsmæssige fradrag [<- In Danish, in English : Taxable deductions] &
Aktieindkomst [<- In Danish, in English : Income from stocks [, or just Stock income]].

The point here is, that results from financial derivatives are taxed as capital income, while the underlying assets [here stocks] are taxed separately as income from stocks.

- - - o 0 o - - -

In short, the regulatory environment in Denmark for taxation of financial derivatives is in the Stone Age. Just try to compare with Sweden [, and now I won't get started ... [ ; - ) ]].

From an economic point of view it's possible to hedge for a Danish private investor, but for me personally it's not worth the hazzle [As a Danish CPA, I live with a tiny asterix (*) in the systems of the Danish IRS, meaning : "Tax audit every year" - and the rest of my life is too short for hazzle with the Danish IRS, when I don't get paid for the hazzle [ ; - ) ].
« Last Edit: February 27, 2020, 02:22:29 AM by John Hjorth »
”In the race of excellence … there is no finish line.”
-HH Sheikh Mohammed Bin Rashid Al Maktoum, Vice President and Prime Minister of the United Arab Emirates and Ruler of Dubai

jhcap

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Re: Hedging exposure
« Reply #6 on: March 21, 2020, 08:26:08 PM »
Selling short or buying put options on GOOGL as a way to hedge a long GOOG position would probably be considered a constructive sale (i.e. no different than if you just sold GOOG).

You should look for tech-focused ETFs that closely track GOOG, something like XLK, VGT, IYW, FTEC...

Hey LC, if I wanted to hedge a further drop in the market of say 15-30% over the next 6-12 months, would it be bet to buy puts on something like SPY? Is it better to buy longer duration than you expect or shorter? Would a LEAP put work in this situation?

ERICOPOLY

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Re: Hedging exposure
« Reply #7 on: March 21, 2020, 09:13:34 PM »
Selling short or buying put options on GOOGL as a way to hedge a long GOOG position would probably be considered a constructive sale (i.e. no different than if you just sold GOOG).

You should look for tech-focused ETFs that closely track GOOG, something like XLK, VGT, IYW, FTEC...

I'm pretty sure you're right about selling short to hedge...

... but I don't think you're right about buying a put to hedge, because there is still the capacity for upside potential.  Because there is the capacity for upside potential, the IRS cannot argue that it is functionally the same thing as selling the stock.  But I do believe it can restart the holding period clock in terms of short vs long capital gains treatment.

If you simultaneously write ATM calls to pay for ATM puts, they'll likely rule that a constructive sale.  Even so, if you reverse the transaction after the stock drops a lot, and you do so within the time period rules, you don't trigger the sale but you have restarted the capital gains clock and you're back to waiting 12 months for long term treatment.
« Last Edit: March 21, 2020, 09:16:43 PM by ERICOPOLY »

LC

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Re: Hedging exposure
« Reply #8 on: March 21, 2020, 09:24:56 PM »
So I would say each portfolio is different. Are you trying to avoid constructive sales (i.e. tax consequences) on a long position in Google? Is your portfolio comprised of index ETFs? Dividend-heavy stocks? Compounders? Are you sitting on heavy capital gains (or losses)? A smart hedge will take these into consideration.

I'll respond generally:

The true hedge is to buy a put option. Volatility is very high these days so option prices are expensive - so if buying puts you will be paying a premium for high implied vol.

You'll want to be aware of how vol is priced across strikes (i.e. the vol smile) - again generally, the volatility premium goes up the further you move away from the at-the-money price - so deep ITM or OTM options have a high premium for volatility as a % of overall price.

Same goes for volatility over time - i.e. the vol term structure. Combine the smile & term structure, and you get the vol surface. Generally, vol premiums drop as you approach expiration.

Other options that kind of accomplish the same:

You can hedge a long position by purchasing a deep ITM LEAP call covering the same notional amount and selling the stock. This effectively gives the same upside exposure (above the strike price) and frees up 50-60% of the position to cash. Really a risk-reduction approach rather than an explicit hedge.

(Also you can create a similar position by keeping the long stock position, taking out a margin loan against 50% of the position, and buying a put option to protect your downside from a margin call. So, multiple ways to extract cash from a long position while maintaining identical exposure.)

You can also sell OTM calls at prices you are willing to sell; this again frees up cash but now you are trading upside.

And, whether you are selling calls or buying puts, you can layer on top - taking opposite positions in different strikes and/or tenors to offset either the risk you are taking (when selling calls) or the premium you are paying (when buying puts). Ericopoly wrote a few good posts recently on why these spreads can be a bit hairy in practice.

Something like, selling June/July calls (which you expect to expire worthless as the world is recovering from COVID); and purchasing December of January calls which you intend to exercise as the world has recovered and earnings yields are below 5%. But that's a hairy bet - a lot can go wrong.  ;D

For me, I was sitting on long positions in Berkshire and Visa which paid little/no dividends. I wanted to free up cash in case the index hits 2000 and below. So I sold half my stock, bought deep ITM LEAP calls for the same notional amount to free up that cash. And I also sold deep OTM calls on the remaining half of stock which I kept, but those expire in June.

With all option strategies it's good to write down exactly how you can lose all your money. Helps structure the position.

For the trade I made, if the index stays here for 3 months, my OTM options expire and I pocket that premium. My deep ITM options still have 2 years left.

If the market skyrockets, well my ITM options are now worth a bunch; and if I get called on the OTM position - well I've sold at a good but not great return.

And if the market tanks over the next 2 years such that my ITM calls are now OTM - well I'll will have pocketed the OTM call premiums, and the money I raised from this trade I can now put to work. So it will hurt, but hurt less than if I was fully exposed.

Essentially I've traded short term upside for long term downside protection - and was able to get a lot more protection than usual due to the crazy high vol premiums when I sold the OTM calls.

For you assuming you're sitting on a 100% GOOG portfolio with very large embedded long term capital gains, for which you want to avoid any sales with tax consequences. You'd want to map out how the above positions would work but instead of using options on GOOG, you find a highly-correlated asset that you expect to maintain that correlation through future downturns. And you'll have to take tax considerations into it.
« Last Edit: March 21, 2020, 09:40:59 PM by LC »
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LC

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Re: Hedging exposure
« Reply #9 on: March 21, 2020, 09:29:25 PM »
Selling short or buying put options on GOOGL as a way to hedge a long GOOG position would probably be considered a constructive sale (i.e. no different than if you just sold GOOG).

You should look for tech-focused ETFs that closely track GOOG, something like XLK, VGT, IYW, FTEC...

I'm pretty sure you're right about selling short to hedge...

... but I don't think you're right about buying a put to hedge, because there is still the capacity for upside potential.  Because there is the capacity for upside potential, the IRS cannot argue that it is functionally the same thing as selling the stock.  But I do believe it can restart the holding period clock in terms of short vs long capital gains treatment.

If you simultaneously write ATM calls to pay for ATM puts, they'll likely rule that a constructive sale.  Even so, if you reverse the transaction after the stock drops a lot, and you do so within the time period rules, you don't trigger the sale but you have restarted the capital gains clock and you're back to waiting 12 months for long term treatment.

I'm not positive on the put option. Selling calls and buying puts is certainly closer because the payoff curve is identical. According to this: https://www.fidelity.com/viewpoints/active-investor/protect-your-profits
Buying a put is viewed as a constructive sale, but this is a footnote in an internet article that ends with "consult your tax advior". So if you have first hand experience and have dealt with the IRS on this, I would certainly defer to that.

These are the constructive sale rules (https://www.law.cornell.edu/uscode/text/26/1259):

(c)Constructive sale For purposes of this section—
(1)In general A taxpayer shall be treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person)—
(A)enters into a short sale of the same or substantially identical property,
(B)enters into an offsetting notional principal contract with respect to the same or substantially identical property,
(C)enters into a futures or forward contract to deliver the same or substantially identical property,
(D)in the case of an appreciated financial position that is a short sale or a contract described in subparagraph (B) or (C) with respect to any property, acquires the same or substantially identical property, or
(E)to the extent prescribed by the Secretary in regulations, enters into 1 or more other transactions (or acquires 1 or more positions) that have substantially the same effect as a transaction described in any of the preceding subparagraphs.
« Last Edit: March 21, 2020, 09:32:41 PM by LC »
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