{"id":222775,"date":"2025-04-28T10:45:00","date_gmt":"2025-04-28T14:45:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=222775"},"modified":"2025-06-06T15:09:44","modified_gmt":"2025-06-06T19:09:44","slug":"tax-aware-hedging-with-options","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/options\/tax-aware-hedging-with-options\/","title":{"rendered":"Tax-Aware Hedging with Options"},"content":{"rendered":"\n

Guest Author:<\/strong>\u00a0Bill Speth, Portfolio Manager, Bosun Options Solutions<\/p>\n\n\n\n

Toward the end of 2024, many Bosun clients shifted their focus from capital appreciation to capital preservation amid growing concerns about a stock market correction. In recent months, a number of sell-side firms have lowered both short- and long-term forecasts for the U.S. stock market. Goldman Sachs has estimated that the S&P 500 will deliver an annualized nominal total return of 3% over the next 10 years1. <\/sup>Over the last 10 years, annualized returns were 13%.<\/p>\n\n\n\n

Some investors who desire to reduce risk will simply sell their riskier holdings and replace them with safer assets.<\/p>\n\n\n\n

But many investors are unable or unwilling to do so. For example, investors who purchased shares at a low basis would face a significant tax event were they to sell their stock. Additionally, they may have an affinity for being a shareholder in a company they have owned for a long time.<\/p>\n\n\n\n

Options-based hedges provide investors with the opportunity to hedge risk while minimizing stock sales.<\/p>\n\n\n\n

The following is meant to serve as a guide to how Bosun thinks about option-based hedging.<\/p>\n\n\n\n

An Introduction to Option-Based Hedging<\/strong><\/h2>\n\n\n\n

Hedging involves taking a position in one or more financial instruments that will directly offset losses in a related asset. Options are particularly useful tools with which to construct hedging strategies. With thousands of unique contract terms available for each security, one can create hedges that target precise levels of protection and cost.<\/p>\n\n\n\n

The table below lists three option strategies commonly used for hedging, each with a different balance of protection and cost.<\/p>\n\n\n\n

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Payoff diagram icons shown under \u201cOption Strategy\u201d header are illustrative and not meant to describe precise payoffs. Shapes of payoff diagrams and strategy descriptions apply only to investments held until option expiration.<\/em><\/sup><\/p>\n\n\n\n

Like other forms of insurance, investment protection is not free. Buying a put requires an up-front payment in the form of the option\u2019s premium but there is no limit to future upside appreciation. There is also a very real possibility that the actual down move doesn\u2019t take place immediately and you may need to maintain a hedge for several months. We find that few investors are willing to use this strategy.<\/p>\n\n\n\n

Collars, on the other hand, tend to be more appealing. They can be structured with minimal or no initial cost, though they come with limited upside potential. Buffered collars provide protection over a limited range of stock price moves and improved upside participation compared to a standard collar. Investors who place a high value on potential upside often prefer buffers to collars.<\/p>\n\n\n\n

Buffered Protection Collar \u2013 A Case Study<\/strong><\/p>\n\n\n\n

Bosun recently helped a client hedge a blue chip stock in their portfolio. The client wanted to protect the gains accrued over many years but did not want to pay substantial capital gains taxes as a result of selling shares. They were willing to accept some losses if the stock fell but wanted to hedge against a major drawdown. The client\u2019s long-term outlook was positive, so they would look to be a buyer of additional shares if the price fell by at least 30%. They also requested a hedge with minimal cost, provided the structure offered meaningful potential for upside appreciation.<\/p>\n\n\n\n

Bosun initiated a buffer protection structure intended to hedge losses in stock over a range of 8% down to 29% down until January 2026. Bosun eliminated the risk of selling stock as a result of an option exercise by using European-style FLEX options. The figure below illustrates the defined payout of the hedge if held to maturity. The hedge offers:<\/p>\n\n\n\n