Successful trading is built on discipline and rules. That means following through on a stated plan, not leaving a job half-finished or letting things slide. With that in mind, I'd like to use this weekend's column to further discuss some subjects that have generated a steady stream of interest over the past few months.


Questions and comments abounded regarding covered calls and my recent column discussing the Chicago Board of Options Exchange's licensing of its BuyWrite Index, or BXM. Many readers wondered about ways to replicate the BXM. Here's an example:

Why wouldn't simply buying S&P Spyders (SPY) and selling near-the-money covered calls be an equivalent yet easy-to-implement vehicle for individuals?

The first thing you need to be aware of is there are no options on the Spyders. So in order to use this method to replicate the performance of the BXM, you would need to make the calculations necessary for adjusting the number of S&P 500 options sold to correlate with the number of long Spyders you hold.

Basically, the value ratio of the Spyders to the S&P 500 is 1:10. That means that for every 100 Spyder shares, you should only sell one-tenth of one S&P 500 call. This could prove problematic for anyone holding anything less than 1,000 shares of Spyders. Even then, the relative commissions involved in selling a single call each month would adversly impact your overall returns.

Another alternative might be to use an optionable proxy for the S&P 500 index. The iShares S&P 100 ( OEF) is an exchange-traded fund representing the S&P 100 index. The current price level is a very economical $47, and its options market is fairly liquid. The correlation between the S&P 500 and S&P 100 is tight enough that you should be able to generate comparable results. But again, this strategy will require constant monitoring and adjusting of the position, which can be both costly and labor intensive.

Unless you have the market savvy, capital and time, this endeavor might be better left to a professional money manager or a fund that uses the covered-call strategy. This brings us back to the real point of the article -- that the BXM (which isn't a fund but an index) provides a valuable benchmark to help separate the good funds from the bad.

Hedges and Taxes

Now that April 15 is safely behind us, I'll touch on the questions concerning taxes and options and their use in hedging strategies. Here's an example:

You wrote an article on using a collar to defer taxes and lock in profits. Can you compare this to writing deep-in-the-money calls against a long position. Wouldn't this be better lock?

Selling deep-in-the-money calls is a reasonable way to hedge an existing position, but it's definitely not more exact. For example, assume you bought 1,000 shares of XYZ many years ago at $15. Say the stock is currently trading at $80. You could sell 10 of the January 2004 $40 calls at $41 each in an attempt to lock in the sale price at $81.

Now, what if XYZ has terrible news that drops the stock by 60% to $32? Your call only protects you down to $39, making your effective sale price $73. Not bad, but not exactly what you expected. Now imagine the stock has a complete meltdown to $5. While this scenario is unlikely, it's not unprecedented.

Before my cursory coverage of the tax implications of options and collars, let me point out that taxes aren't my field of expertise. You should always check with an accounting professional concerning your specific tax situation. But here are some general rules I can pass along.

Profits from selling calls, like shorting a stock, will always be treated as a short-term capital gain no matter the length of the holding period. Selling deep-in-the-money calls against an existing long stock position will be treated as a constructive sale. A constructive sale is defined by the Internal Revenue Service as "having made a sale at the moment you enter into short sale of the same or substantially identical property."

That means you'll recognize any gain at the price and date of the sale. Making matters worse is the fact that you'll have a new cost basis and holding period assigned on the date of the constructive sale. The purchase of in-the-money puts may also be considered a contructive sale. But any realized loss or gain on puts, if held for a sufficient time period, could be deferred and treated on a long-term capital-gain basis until the physical delivery (sale) of your long stock.

The use of a collar might be one way to lock in a definite sale price while not being construed as a constructive sale. A collar is a strategy in which a lower strike put is purchased while simultaneously selling a higher strike call, and where both have the same expiration dates. But a collar still exposes your position to some risk.

For example, you could buy 10 XYZ January 2004 $75 puts for $5 and sell 10 January 2004 $85 calls for $5. Commissions aside, this would be an essentially cost-free transaction. This approach collars the sale price of your 1,000 shares of XYZ between $75 and $85, but defers the long-term capital gain on the underlying shares of XYZ. The $5 inherent risk may be sufficient to avoid the designation of a constructive sale.

But again, always speak to an expert because the "tax straddle" rules, which attempt to place limits on hedging transactions that are done solely for the purpose of recognizing losses and deferring gains, are fairly complicated and open to interpretation. I'll devote some more space to this subject in a future column.

So, thanks everyone for the great response to my six first months at the and RealMoney, and I encourage you to keep sending in the questions and comments.
Steven Smith writes regularly for 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.