This delta variant would kill covered calls and risk reduction moves.
Do you ever write calls against your stocks in order to generate premium income? Do you buy puts to protect your gains? Enjoy options while you can. These time-honored strategies may be doomed.
Trouble comes via U.S. Senator Ron Wyden, a liberal Democrat from Oregon who presides over the Senate Finance Committee. His plan to tax billionaires on their paper gains is now under intense debate. Less visible: his parallel scheme to go after investors who use derivatives, like stock options.
The billionaire tax and the derivatives tax are separate pieces of proposed legislation. They have in common the scary concept of “mark-to-market” taxation, under which you owe tax on appreciation even if you haven’t sold an asset.
Until recently, extending the income tax to paper gains would have been considered a long shot in Congress. But now, with politicians hungry for revenue to finance social spending, a paper-gain tax of some sort is plausible. A more straightforward revenue source would be a boost in the top tax bracket, but the Democrats are evidently a vote or two shy of what they need for that move.
Wyden might or might not succeed with his plan to snatch some of Elon Musk’s and Mark Zuckerberg’s fortunes. But, as pressure builds for tax hikes, it would be easy to nail derivatives players. Options and futures look like games that rich people play. Alas, the proposed crackdown on options hits not just plutocrats but moderately prosperous types saving for retirement.
The Modernization of Derivatives Tax Act of 2021, introduced by Wyden in August, does three drastic things to option investors.
(A) It extends mark-to-market accounting, which now applies to commodity futures, stock-index futures and options on stock indexes, to options on individual stocks.
(B) It kills a 40-year-old compromise on tax rates for mark-to-market investments. They are now taxed as if 60% long-term capital gains, 40% short-term, regardless of how long positions have been held. Under the bill, they would be taxed as generating 100% ordinary income.
(C) It causes option trades to trigger capital gains on underlying stocks.
Odds of enactment? One in three, hazards Roy Haya, head of derivative solutions at Fort Point Capital Partners, a San Francisco firm that advises other wealth managers how to manage risk for their clients. And what would the bill do to Haya’s line of work? “Wrecks it altogether.”
Haya is most upset about what is listed above as item C. An investor who sells covered calls against a stock position would first have to undertake a complicated calculation involving the “delta” of the option, then segregate the stock holding into a portion that is safe and another portion that would be deemed to have been sold.
The problem, says Haya, is that the tax bill on the fictitious sale would often swamp the income pulled in from writing the call. So the investor just wouldn’t sell that call. He wouldn’t buy a protective put, either, because that would also trigger a tax bill. “This bill makes it much, much more expensive for the average investor to mitigate risk,” Haya says.
Per a report from Wyden’s committee, modernizing tax rules on derivatives would raise $16.5 billion over a decade. Small change in a world of trillion-dollar deficits. But there are no politicians giving speeches about how we need derivatives to save the family farm. So maybe the risk to average investors is worse than one in three.
Haya outlines what the proposed legislation would do to you if you own some Apple and want to use options. Say you bought 1,000 shares a while ago at a split-adjusted $10. The stock was recently trading at $148. You remain modestly bullish on the stock but want to take some risk off the table.
A classic way to do that is to set up a collar. You sell ten January 2022 call options (each for 100 shares) with a $155 strike price. That would generate $3,900 of premium revenue. You use some of that income to buy ten put options with a $130 strike.
Wyden’s bill would stop you dead in your tracks. Depending on where you live, you could wind up with a $25,000 tax bill, even without being in a top tax bracket.
Here’s how you do your taxes. First, you calculate the delta on the call. This is defined as the partial derivative of the option price with respect to the stock price. Easy to do if you are familiar with the Black-Scholes option formula. (Aside: The similarity of this “derivative” to the word in the bill’s title is coincidental.) You’ll come up with a number close to 0.36.
Repeat this exercise for the put. The result there is going to be in the vicinity of -0.16.
Calculate the algebraic difference between these two numbers. Answer: 0.52.
Now divide 0.52 by 0.7. The bill plucks the latter number from the air; it seems to have been inspired by a longstanding IRS regulation defining two portfolios as “substantially similar” if there’s a 70% overlap.
Take the quotient and multiply by 1,000, arriving at 743. When you do your tax return, pretend that you sold 743 Apple shares, which creates a long-term gain on them and resets their holding period and cost basis. If you sell any of the Apple, keep track of whether you are selling the original shares or the ficticiously sold shares.
Says the committee report, “This bill closes key gaps in the tax code currently exploited by those seeking to avoid tax.”
But existing law scarcely allows option traders to get off scot-free. If that call you write expires worthless, the $3,900 is a short-term gain and will probably be taxed at high ordinary-income rates. Also, if the collar is too tight, you have a constructive sale. Selling a $155 call while buying a $155 put would eliminate your risk in the stock and, under existing law, force you to report a capital gain on the entire 1,000 shares.
What about covered-call programs? Some people buy stocks, then immediately write out-of-the-money calls on the stocks. This doesn’t increase the expected return on equities, but it does increase their cash flow, a convenience in an era of low yields.
The Wyden bill wouldn’t cause much of a capital-gain problem for covered-call investors, at least in newly acquired portfolios, but it would create an accounting nightmare. If it’s enacted, covered calls outside tax-sheltered accounts are dead.
Is Musk going to be writing out a $50 billion check to the U.S. Treasury? Maybe. Are average investors going to get modernized? Quite possibly.