Nuanced Tax Efficient Risk Management: Options Hedging And The 50/50, 75/25 Traditional Portfolio
Summary: Tax Efficient Strategy Using Options
The strategy involves buying PUT options alongside equities to hedge downside risk. While PUTs do not eliminate risk, they serve as an insurance like wrapper for stock or ETF positions. The tax treatment allows for a long-term capital gain on the equity, while the loss on the PUT may offset other gains. More return and better tax management is what this strategy is all about. The PUT is not used all the time although it can be if you wish. Knowing the macro environment, the situation, and the drag of the PUT will influence whether it’s used or not.
Tax Efficient Strategy
A PUT option acts as a hedge for a stock, ETF, or portfolio.
A PUT does not eliminate risk it manages it.
Example of the hedging strategy:
Buy Stock A at $100
Buy PUT option at $5
After 13 months Stock A is now worth $115
The PUT option has expired worthless.
Capital Gains:
Cost basis = $100
Current price = $115
Long Term Capital gain = $15
Capital Loss:
The $5 PUT option. (expired worthless)
Net Capital Gain:
$15 long term capital gain - $5 capital loss = $10 total gain.
If the long term capital gain tax rate for this client is 15% and taxes owed on the full $15 dollar capital gain is $2.25 (15 x 0.15 = $2.25) and after we take the capital loss on the option of $5, taxes will only be owed on $10. The taxes owed for $10 is $1.50 (10 x 0.15 = $1.50). The tax savings for this client in this scenario is $0.75 ($2.25-$1.50 = $0.75). In this simple example we decreased the client’s tax bill by 33.33% (0.75/2.25)*100 = 33.33%. This is powerful, just imagine if you are working with millions or billions of dollars? The tax savings could be in the millions. This is not even taking into account normal tax loss harvesting with stocks and ETFs. If you have a traditional equity/bond portfolio you better hope you have some losses or can find them somewhere to offset that capital gain you will have from selling Stock A. If you do not you will be paying 33.33% more in tax.
Return potential of the Equity/Options mix VS the Equity/Bond mix:
Real World Example (2023)
Return of SPY (S&P 500): 26.19%
50/50 and 75/25 Equity/Bond Mix:
Average Bond Return: 5.53%
SPY Return: 26.19%
50/50 = (0.50*26.19) + (0.50*5.53) = 17.36%
75/25 = (0.75*26.19) + (0.25*5.53) = 21.03%
Equity/Options Mix:
10% downside protection: Drag = 3.8%
SPY Return = 26.19% - drag of 3.8% = 22.39%
20% downside protection: Drag = 2.8%
SPY Return = 26.19% - drag of 2.8% = 23.39%
Outcome:
The equity/options mix beat the equity/bond mix by 5.03% for the 50/50 traditional portfolio and 2.36% for the 75/25 traditional mix.
Pros and Cons:
Pros:
Tax Efficiency:
Long-term capital gains from equities.
Potential tax-loss harvesting from PUT options.
Downside Protection:
PUT options cap losses while allowing upside participation.
Better Risk-Adjusted Returns:
Strategy can outperform equity/bond mixes, especially in bull markets.
Customization:
Protection levels (e.g., 10% vs. 20%) can be tailored to investor risk tolerance.
Keeps Portfolio Growth-Oriented:
Unlike bonds, PUTs don’t limit growth during market upswings.
Cons:
Cost of Protection:
PUT premiums reduce returns (drag of 2.8%–3.8% in the example).
Options Complexity: (not really a con, I have done this so many times)
Requires more management and knowledge than traditional portfolios.
Loss of PUT Premium: (not really a con because you will be able to tax the capital loss and it will help you with your taxes)
If the market rises, PUTs expire worthless, leading to a realized loss.
No Interest/Income: (could be a pro or con depending on what the market does)
Unlike bonds, PUTs don’t generate yield or dividends.
Potential for Poor Timing:
Buying protection at the wrong time (e.g., during low volatility) may lead to ineffective or costly hedges.
