Last week you talked about avoiding wash sales by doubling up on losers for tax credits. How about ways to use options to defer profits? What, if any, are the rules for locking in gains? Thanks and keep up the good work. -- J.G.

If you see limited upside and have held the stock in question for 12 months -- and therefore qualify for the lower capital gains tax rate -- the best and surest way to lock in gains is to simply close out the position. That said, there are some strategies for protecting a substantial

portion

of gains, while deferring them beyond the current tax year.

Before mentioning these techniques, I need to repeat last week's disclaimer:

"Remember that you should always consult a qualified tax expert before making any transactions. Tax laws, especially those related to investing, are notoriously complex and constantly changing. Each situation is handled differently. I'm not a tax expert, but one thing I can say without equivocation is this: Don't try to use options to avoid taxes. If you owe taxes, you will pay -- one way or another."

That said, there are certainly valid reasons for maintaining a position, beyond the desire to simply defer taxes. There is an interest in maintaining exposure to further upside potential in the stock, and in the case of dividend-paying stocks, to keep receiving income. With the new tax laws assessing only 15% on dividends, the latter becomes even more compelling, but as you'll see in a moment, there are a few methods for reducing risk while maintaining a long position. One side note to be aware of: Short positions are almost always considered as short-term gains or losses and taxed at the higher income rate. One options strategy would be to

create a collar around an existing stock position. A collar is a three-piece position constructed by selling a call and buying a put option in conjunction with a related long stock position. The collar's effective sale prices are defined by its net cost (the sale price of the call minus the cost of the put) added to the strike prices.

For example, with

Research in Motion

(RIMM)

trading at $92 per share, one could buy the January 2006 $80 put for $14 and sell the January 2006 $110 call for $15, giving you a net credit of $1. This means you have collared your long RIMM shares at an effective sales price no lower than $81 and no higher than $111 per share.

It is very important to note that the collar is wide enough so that some risk remains in holding the long stock position. Otherwise, it would be deemed a

constructive sale. A constructive sale might trigger a taxable event and will cause the holding period to begin anew, starting at the date the constructive sale position was established.

In the example above, the RIMM position is still exposed to a 11.9% decline from the current price (and also offers 20% upside potential), and therefore should not be considered a constructive sale. The rules are somewhat complex and are dependent on variables such as the price of the stock and the length of the time the protection is in place. But a good rule of thumb is that a 10% risk will avoid it being considered a constructive sale.

The same issues surround using covered calls to maintain a long position. The new rules governing

qualified covered calls, which were just updated this past October, are more stringent. In the past, calls that were one strike in the money, if there was sufficient time remaining in the contract, qualified as being exempt from tax deferral rules. This is no longer true. Now, even at-the-money calls will be deemed a constructive sale, so you must sell calls that are at least one strike out of the money. The reasoning for the tightening of the rules seems to stem from the reduction in dividend tax rates. With dividends now being taxed at only 15%, the feeling is investors should not be able to collect the dividend income relatively risk free.

For more details on the regulations, you can look at the Options Clearing Corp.'s (OCC)

Guide to Taxes and Investing. It explains the rules no better or worse than any other free source and is a good place to start. It spells out what is clearly not allowed and arms you with information so you can smart-bomb your tax professional with intelligent questions concerning the gray areas of your situation.

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@thestreet.com.