Strategies for Hedging and Diversification

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Strategies for Hedging and Diversification
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
July 24, 2007

In Hedging Your Investments, we covered the basics of hedging your portfolio against potential loss. Here, we look at some common strategies for hedging, tax deferral and diversification.

Temporary short against the box
Going short against the box (SAB) means you sell short a position equal to the long position you wish to protect (selling short means you borrow shares from your broker and sell them). The word "box" refers to days gone by when folks routinely kept physical stock certificates in safety deposit boxes. The SAB strategy effectively locks in your current gain, because any further price movement will be offset by one side against the other. Shorting against the box requires a margin account. Borrowing in a margin account may increase your costs to the extent you incur margin interest expense.

Shorting against the box used to be a great way to indefinitely defer recognition of gain for tax purposes with no downside (or upside) potential. The constructive sale rules introduced in the Taxpayer Relief Act of 1997 changed all that. You can still go SAB. However, if you fail to close out the short position before 30 days after the end of the calendar year in which you entered into the transaction AND leave the original appreciated position unhedged for at least 60 days after you close out the short, you'll be hit with a constructive sale as of the date you entered into the short position. That means you'll be taxed on your original gain even though you didn't actually sell the shares.

One way around this issue would be to use a similar, but not substantially identical, security for the short sale. This wouldn't provide a perfect hedge, as a true SAB strategy would. But it could provide material protection from loss while avoiding the constructive sale rule. For example, if you have a well-diversified portfolio of U.S. large-cap stocks, you might be able to hedge your position by shorting an equivalent value of a well-correlated, large-cap exchange traded fund.

The SAB is relatively easy to implement and may still be useful, but only as a temporary hedge. A protective put, while potentially more costly, is just as easy to implement and could provide more flexibility (more below).

Writing covered calls: limited downside protection
A call option gives the buyer the right, but not the obligation, to purchase the underlying security at a predetermined price for a specific period of time. The call option buyer pays a premium for this right of future purchase.

On the other side, the seller ("writer") of the option receives the premium and must be ready to deliver the underlying shares should the option buyer elect to exercise the right to buy.

Writing naked calls—selling call options when you don’t own the underlying stock—can be risky because your potential loss is unlimited. For example, if you write a call option for XYZ with an exercise price of $10 and the stock goes up to $20, you would have to buy the shares for $20 and deliver them for only $10 to the option holder—a $10 loss per share (not including transaction costs, and less whatever premium you received for writing the call). However, if you'd written a covered call on shares you already owned, you could simply deliver the shares to the call option holder to close out the contract.

Writing covered calls is a fairly straightforward and conservative strategy whereby the additional income you receive (the premium you receive for selling the call option) can provide some limited downside protection.

For example, let's say you own 1,000 shares worth $10 each. You write three-month call options and receive a total premium of $500 for giving the buyer the right to purchase 1,000 shares from you at $12 each. If the share price goes nowhere for the next three months, you pocket the $500. In the meantime, you've given yourself a little downside protection—the shares could drop to $9.50 and you would be even, not including taxes and transaction costs.

There are a few caveats. First, as the share price rises above $12, your chances increase that the option buyer will exercise the options and call your stock away. For example, if the price rose to $15 you would still be required to deliver your shares for $12 under the option contract. The $3 difference represents an opportunity cost to you (you could have sold the shares for $15). And although it rarely happens, remember that the option buyer can exercise the options even if the share price is below $12.

Second, you will have to recognize for tax purposes any gain on your original shares at the time you deliver them.

Finally, keep in mind that writing a covered call typically creates a straddle (see Hedging: Tax Traps For The Unwary). In this case, your underlying shares offset the risk associated with your written call position. If you decide to keep your original shares to avoid recognizing gain on them, you could always go out and purchase new shares to deliver at a loss. However, the straddle rules mean you won't be able to take that loss for tax purposes until you dispose of your original shares and recognize the gain. There's an exception to this rule called a qualified covered call—for details, consult your tax advisor or see IRS Publication 550: Investment Income and Expenses.

Protective put
When you buy a put option, you have the right to sell (or "put") the underlying shares to the put option seller at a predetermined price for a specific period of time. For example, if you own 1,000 shares of a stock valued at $10 per share, you could purchase put options on the position that give you the right to sell 1,000 shares at $9.50 per share for a specific period of time. As long as the put options last, your total potential downside is limited to $500 (excluding commissions and the premium you pay for the put option). What's more, you keep the door open for any subsequent appreciation.

Importantly, although put options create a straddle position, a put option by itself (at-the-money, or below) should not trigger the constructive sale rules. What's more, in many cases you can borrow against the hedge, up to 90% of the protected position, depending on how you use the proceeds of the loan (the limit is 50% if the sole purpose is to buy new securities).

Under the straddle rules you would need to capitalize any interest charges on the money you borrow (which means the interest expense wouldn’t be currently deductible). And of course, you'll have to pay a premium to purchase this sort of put-option "insurance"—although you could potentially mitigate the premium expense through an equity collar or variable-share prepaid forward contract (see below).

Charitable remainder trust
A charitable remainder trust is more than a gifting strategy. A CRT can help you immediately diversify an appreciated concentrated position, defer taxation on the gain, and provide a current charitable tax deduction and ongoing annual income from the trust.

Once you've set up the trust (you'll need an attorney to draft the trust document), you establish a brokerage account in the trust's name. After you transfer your shares into the trust account, you could sell your concentrated position and reinvest the proceeds in a diversified manner, as appropriate. The gain on sale, along with any potential ongoing current income or appreciation on the trust portfolio, is taxed only when funds are withdrawn from the trust, typically on an annual basis over a period of years.

A CRT requires ongoing tax filings and trust maintenance, so be sure to consult your tax professional about suitability and costs. Remember, you must have charitable intent going in—you are required to make an irrevocable gift to charity of the trust's remainder interest.

More sophisticated strategies
For these hedging strategies, providers typically will consider larger positions only. For example, Schwab's Strategic Trading Group will gladly handle positions of $1 million or higher.

Equity collar
With an equity collar, you simultaneously sell (write) a call and purchase a put. Typically, equity collars are privately negotiated, over-the-counter contracts written directly between the investor and the financial provider. Theoretically, however, you might be able to create a collar using listed options traded on an exchange, if available.

A common technique is the zero-cost collar, where the premium received on the written call offsets the premium paid on the put purchase. However, there's still a potential opportunity cost—the value of your shares could rise beyond the exercise price on the written call option.

Importantly, a properly structured equity collar can avoid constructive sale treatment by allowing a limited price band within which the stock could potentially move during the life of the collar. The collar can't be too "tight," though, or the IRS might deem it abusive under the constructive sale rules.

An equity collar is a superior hedging strategy compared to the temporary short against the box in part because you can avoid a constructive sale for a longer time period (one to three years, for example). What's more, the premium you receive for writing the call means you're not paying for the downside protection out of pocket, as you would be if you only used a protective put—although you are giving up potential upside appreciation past the exercise price on the written call option.

Additionally, once collared, your shares can make excellent collateral. You can typically borrow up to 90% of the value depending on the situation and how you use the money (the limit is 50% if the sole purpose is to buy new securities).

Variable-share prepaid forward contract
This strategy is very similar to using an equity collar. However, instead of borrowing against the value of your collared shares, you receive a cash payment equal to the discounted forward sale price of your shares.

The forward contract typically requires you to deliver your shares at the end of the contract period, or opt for cash settlement if you want to retain your shares at that time. Because the contract usually provides for the equivalent of 100% put protection (no downside) and a band of appreciation to the upside, at worst you would simply deliver all your shares at the end of the contract—though you could be required to deliver fewer shares in the event the price had gone up. Either way, recognition of gain is deferred until such time as you deliver the shares.

As a hedging strategy, a variable-share prepaid forward contract has a number of advantages. If structured properly, it can avoid the constructive sale rules for an extended period of time (typically one to three years) and provide 100% downside protection while retaining upside potential. Also, you can typically use all the cash you receive up front to buy new investments, compared to the usual 50% limit of a collateralized security loan.

Exchange fund
A typical exchange fund brings together eligible investors with qualified assets. The investors contribute their securities to the fund in exchange for an interest in what is now a diversified pool of investments.

One problem with exchange funds is that your assets are typically locked up for seven years. After that, you receive an in-kind stock distribution from the fund consisting of your share of the diversified holdings. Also, an exchange fund can provide for diversification and deferral, but you can't borrow against your shares.

Important factors to look at when evaluating an exchange fund include:

Fees and expenses
Other securities in the portfolio (there's always a chance you could end up contributing the one stock that appreciates more than the rest in the portfolio, in which case you would have been better off without the exchange fund)
Provisions for withdrawals prior to the required holding period

The bottom line
We're only scratching the surface here. Whether one or more of these strategies is appropriate for you depends on the unique circumstances of your particular situation. Remember, sometimes the best strategy is simply to sell, recognize your gain, pay your taxes and move on. Consult your investment advisor and tax professional about which approach is best for you.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call your local Schwab office or write Charles Schwab & Co., Inc. 101 Montgomery Street, San Francisco, CA 94104 for a current copy.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies may not be suitable for you. We believe the tax information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

Charles Schwab & Co., Inc., Member SIPC.

(0707-6389)

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