An Options question?

Question

How do I figure out a perfect hedge, or near perfect, using options(puts) against a long stock position? For example, I own 500sh of XYZ and I have a 1 point gain in it. I believe the stock will take a hit but I don't want to sell the stock yet . How do I figure out how many puts to buy against the long position to essentially "freeze" the position and lock in the gain, so that no more gains or losses would be possible? This is for a short period of time(3-5 days) so time decay would not be an issue. Basically I want the effect of a shorting against the box, but using options instead. Thanks.

Answer 1

The equivalent of a short stock position of 500 shares would consist of

1. long 5 puts
2. short 5 calls

where the calls and the puts have the same strike price and expiration date.

If you you combine this synthetic short stock position with a long position in the stock itself, you have a what is called a conversion.

Let me add a little more information. If you are thinking of doing this for tax purposes, and you pay United States taxes, there are tax rules that will prevent you from getting any advantage.

First, see the "constructive sales" rules on page 40 of IRS Publication 550. For tax purposes, a conversion will be treated as a constructive sale and you will have to treat your stock position as if you sold it and repurchased it on the day you opened the options positions.

Second, if you want to do this in an attempt to keep the stock long enough that any gains will be treated as long term capital gains, there's another gotcha. The IRS calls offsetting positions "straddles" and has a whole series of rules about straddles, one of which is that the beginning of your holding period is reset by a straddle. If you brave/foolish enough to want to know more about the straddle rules, or if you simply want to spend a lot of time trying to understand something, you can find the rules dealing with straddles beginning on page 58 of IRS Pulication 550.

One alternative you might want to consider is to simply sell the stock and then sell five short term at-the-money put options. If you are correct and the stock does go down you will repurchase the stock at a slightly lower effective price, and if you are wrong you will at least have the addition profit from the put options expiring worthless.

Answer 2

What is a "reset" in short selling stocks

Answer 3

ummm... why hedge against the gains?