If you quickly relegated last week's column on

losers to the scrap table, perhaps a discussion of this year's plateful of profits will provide a more appetizing course this week. The market's big bounce on Monday went a long way toward erasing fears of a year-end meltdown, keeping the indices on track to deliver double-digit percentage returns, and securing 2003 as a year of plenty.

But woe to anyone who takes for granted the bounty that has been so kindly delivered, for their regret shall grow proportionate to their want should the current fecundity of profits enter a barren period whence 2004 commences. So I say: Gather ye rosebuds while you may.

Or at least be prudent and take some partial profits. One way to lock in gains is to use options through positions known as collars. This involves the purchase of a put with the simultaneous sale of a call with a higher strike price but the same expiration date. The position defines the parameters -- both high and low -- under which one would be willing to sell an existing long position in an underlying stock during a specified period of time.

For example, with

Dow Chemical

(DOW) - Get Report

trading at $37.30, you could buy the March 35 put for $1.10 and sell the March 40 call for 80 cents. The long shares are now collared between $35 and $40. If upon the March expiration, the stock is either above $40 or below $35, you will have effectively sold out your long position at $39.70 or $34.70, respectively.

Do Not Mess With the Tax Man

Since collars (their use, misuse and abuse) have tax implications, and are often used as a way to defer taxes on capital gains, I must repeat my disclaimer and warning from last week: You should always consult a qualified tax expert before engaging in any transactions. I'm not a tax expert, but one thing I can state without equivocation is this: Don't try to use options as a means to avoid taxes. If you owe taxes, you will pay -- one way or another.

"People need to realize what they are doing with a collar," said Matthew Shapiro, president of MWS Capital Consultants, a Chicago investment advisory business that specializes in using options to manage risk for high-net-worth investment portfolios.

"People try to get too cute and unless there is a legitimate reason for using collars or even selling calls, we advise our clients to pare down holdings by selling a portion of the existing position," he noted.

"Given the complexity and ever-changing nature of tax rules, especially as it pertains to mixed straddles and constructive sales rules," Shapiro is very reluctant to establish positions that are driven by tax considerations. Even if the strategy has merit or other advantages, he always consults with a legal and accounting professional.

But legitimate reasons exist that would suggest employing a collar rather than selling off shares of the underlying. Given the current low interest rate environment, holding shares of a company that pays a dividend may be a basic part of your investment strategy.

Another benefit is that it provides for the potential of additional gains. The advantage of using the collar over entering a "one-cancels-other" order (sell Dow at a $34.70 stop and at a limit of $39.70) is that, while the stock limit orders will be executed as soon as either price level is hit, the collar can be maintained, and the long stock held even if Dow shares trade through the price points before expiration.

At Dow's current price of $37.30, it is up about 24% this year. The company also pays an annual dividend of $1.34 a share, giving it a current yield of 3.59%. By establishing the collar described above and keeping the long stock position, you'd qualify for the next two quarterly dividend payments. The position also provides for an additional gain of $2.40 a share, or 6.4%, over the next four months. Of course it also leaves you exposed to the possibility of losing $2.60 a share, or 6.9%, during the same time period.

Keep the Collar Loose

As part of its 1997 tax act, Congress included a provision regarding a "Constructive Sale of Appreciated Property," which was defined as "having made a sale at the moment you enter into a short sale of the same or substantially identical property."

The "substantially" part would include options, and in essence, Congress sought to prevent people from removing the risk from existing positions while maintaining and benefiting from said holdings. (Here's a useful article on

constructive sale rules.)

Depending on the volatility of the underlying stock, the separation between the strikes of the put and call options, and the length of time remaining until expiration, certain collars may not be considered a constructive sale, which would allow you to secure a profit but defer the recognition of taxable gains.

These positions will be addressed by the Internal Revenue Service and scrutinized by the

Securities and Exchange Commission

on a case-by-case basis, but "a good rule of thumb is that the position should still be exposed to a 5% loss over the next three months," said Tom Byron, a financial consultant with New York-based Blay Asset Management. Due to the collar's basic structure, this also means that one should be able to enjoy a 5% gain over the same time period.

In addition, if either the long put or short call moves into the money, it may trigger a short-term loss or gain that might fall under tax-straddle rules (an investor with a capital gain takes an option position creating an artificial offsetting loss in the current tax year and postponing a gain from the position until the next tax year) and not be allowed or recognized as an offset. Stricter rules are currently being added regarding tax straddle positions and the treatment of selling deep-in the-money calls and puts to defer taxes.

The Senate Finance Committee recently passed a provision that would even eliminate the "qualified covered calls" (calls that are not short term and not written in the money) exemption from tax-straddle rules. For more information on the rules governing options and taxes, see the "Taxes & Investing" section of the

Options Clearing Corp. Web site.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.