Put Option Strategy Versus The “Playing With The House’s Money” Scenario - Advantages Therein

The following article will contrast a two protection/profit strategies, with the goal of illuminating the option that best protects the position and limits tax liabilities.

A U.S. Investor that had purchased DIS stock at the close of the week August 9th, 2013 would have roughly a 100% gain as of the close of trading on August 4th, 2015. A very common strategy for traders and investors, when they have a 100% gain, is to sell ½ and "…let the rest ride." We will take a look at the tax implications of that behavior and contrast that with an options strategy to see if we can lessen the tax burden.

Standard Scenario: Mr. Bob Investor is a university professor who earns $100,000 a year and purchased 1000 shares of Disney on August 9th, 2013 at the cost of $64.73 (for a total purchase cost of $64,730) and those same shares are now worth $121.69 (total value of $121,690) at the close of trading August 4th, 2015 (1).

If Mr. Investor wants to lock in some gains he can take the very common approach of selling ½ of his position (500 shares) for approximately $62,000 and letting the rest of his position 'ride'. A common phrase used to depict this scenario is "playing with the houses money". The idea is that you have taken back your initial investment and therefore don't have any 'risk on the table'. Some of us in the University of Michigan's Global Investment and Research Group firmly feel that this mode of thinking is a fallacy, but that assessment is more fitting for an additional project. Back to Mr. Investor… if Mr. Investor sells ½ of his position for approximately $62,000, he will now have to pay taxes on those gains at a rate of 15%(2) which equals an approximate tax bill of $9,300.

Note 1: Keep in mind that Mr. Investor has also given up on the "upside" of 500 shares worth of Disney in order to "lock in this gain". Therefore, if Disney continues to climb north on its stock chart, Mr. Investor will now earn $500 per $1 increase in share price, instead of $1000 per $1 increase in share price.

Note 2: An extremely important note here is that the remaining 500 shares are NOT protected on the downside with this strategy.

Alternative Method Using Put Options:

Instead of selling half of the position, Mr. Investor could have priced the 'at the money' put option LEAPS for 2016 and then sold the approximate value of shares required to purchase the maximum amount of options. Example: At the close of trading on August 4th, the January 2016 120 strike puts could have been purchased for $565 per contract (3).

To fund this, Mr. Investor could have sold 100 of his shares for a total value of $12,169, paid tax of $1,825.35 on those proceeds, and been left with $10,343.65 from which he could purchase 9 put option contracts to protect the remaining 900 shares. The total cost of those 9 put option contracts would be $5,085 ($565 X 9), and this would leave Mr. Investor with $5258.65 ($10,343.65 - $5085) which can then be used to purchase an additional 9 put option contracts at the expiration date of the first set of nine.

Note 1: Keep in mind that with this scenario Mr. Investor has only given up the upside of 100 shares worth of Disney in order to "lock in his gain". Therefore, if Disney continues to climb north on its stock chart, Mr. Investor will continue to earn $900 per $1 increase in share price, instead of only $500 in the first example (Standard Scenario).

Note 2: With this scenario, the shares are completely protected on the downside all the way to the point of expiration (end of trading day, third Friday of January). Also, there is approximately $5000 available to purchase an additional set of put option leaps to 'roll the contracts' further out in time, at no additional cost.

Note 3: to make this clear, the gains are 'locked in' with this scenario because those put options can be sold (along with the stock if desired) at any point in time. Should Disney share price decrease from $120 to $80, the shares would lose $4000 in value per 100 shares, but the put option contracts would increase in value at the exact rate that the shares value is lost. There would be an overall decrease in the shares to the tune of $36,000, but the put options would increase in value by $36,000. This is how this scenario 'locks in' the profit. And you obviously have 400 more shares still in the market at which your investments value can grow, along with the fact that you paid $7,475 less in tax ($9,300 - $1825) versus the 'Standard Scenario'.

BRIEF HIGHLIGHTS OF BOTH OPTIONS:

STANDARD SCENARIO

1- Sell 500 shares at $62,000, pay $9,300 of tax on that sale.

2- Keep 500 shares in the market, were this misinformed individual is now "playing with the houses money".

3- Zero protection to the downside. If Disney sells off ten points, Mr. Investor has just watched the value of his investment decrease from approximately $62,000 to $57,000 (500 shares X's decrease of $10 a share = decrease of $5000)

4- Remaining upside is $500 per $1 increase in Disney share price.

ALTERNATIVE PUT OPTION METHOD

1- Sell 100 shares at $12,169, pay tax $1825.35 on that sale.

2- With the remaining $10,343.65, use $5085 to purchase 9 "at the money" January 2016 put option contracts at $565 each.

3- There is also $5258.65 left over from #2, from which an additional set of 9 contracts can be purchased at the expiration of the first set. All of this is done at no extra charge, and purchasing them at the expiration of the first set allows one to mark the purchased strike directly at the money, at the time of purchase.

4- This strategy offers 100% "dollar for dollar" protection to the downside from the strike price of $120 down to (effectively) zero… until the point of expiration. *(keep in mind #3, which notes that there is an additional $5258 to purchase additional put contracts to protect the position yet even further out in time.

5- Remaining upside is $900 per $1 increase in Disney Share price. Only 10% of the position is sold to lock in the gains of

Ending Notes:

1. You will get a slightly different outcome if you are dealing with a tax free account of some sort (IRA, 401k, etc.) but you still come out much further ahead on a taxed basis.