Buying a Put Option to Protect a Profit




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In the first example, the stock which had cost 30 had been held for only 4 months when the Put was bought. If the taxpayer had made a short-sale instead of buying a Put, the special rule would have become applicable .

In the two preceding examples, the trader bought a 90-day Put option .. and this is what happened.

In the first example, he was protecting an unrealized profit of 20 points (he had bought the stock at 30 and four months later, when the stock was at 50, he bought a Put at 50). In the second option he protected himself against loss on a new commitment (he bought the stock at 50 and at the same time he bought a Put at 50). The first type of transaction brings into play a special rule of the federal income tax law; the second type of transaction brings into play an exception to that rule. The special rule states that if a taxpayer makes a short-sale of stock and (1) if at the time of making the short-sale he has held the same stock for not more than 6 months, or (2) if, while the short-sale was open, he has acquired more of the same stock, there will be two consequences:

First, any gain on closing the short-sale will be a short-term capital gain, even though the short-sale is closed by the delivery of stock that, at the time of delivery, has been held for more than 6 months.

Second, the holding period of the stock that at the time of the short-sale had been held for less than 6 months or had been acquired while the short-sale was open, starts on the day the short-sale is closed. The length of time that the stock was held before the short-sale was made and the length of time it was held while the short-sale was open are ignored.

For the purpose of applying this special rule, the acquisition of a Put is considered to be the making of a short-sale, and the exercise or the expiration of the Put is treated as the closing of a short-sale.

In the first example, the stock which had cost 30 had been held for only 4 months when the Put was bought. If the taxpayer had made a short-sale instead of buying a Put, the special rule would have become applicable.


Since the acquisition of a Put, under these circumstances, is the making of a short-sale, such acquisition made the special rule applicable. If, when the Put expires, the market is 70 and the trader sells his stock at 70 at a time which is more than 6 months after the date of the acquisition of the stock, but not more than 6 months from the date on which the Put expired, his gain will be short term, despite the fact that he has actually held the stock for more than 6 months.

If the market is 50 or under at the expiration date of the Put, and he exercises the Put by delivering the stock which he bought at 30, his gain will be short term even though at the time of the delivery his stock has been held for more than 6 months.

If, however, he did not buy the Put until after his stock had been held for more than 6 months, the special rule would not apply for the reason that the conditions that bring the rule into play would not exist; i.e., the Put was not acquired at a time when stock had been held for not more than 6 months nor was any stock purchased while the Put was in force. Consequently, any gain on the sale of the stock, whether from a sale in the market (at a price above the price in the Put) or delivery upon exercise of the Put, will be long term.

If, when the trader buys a Put on 100 shares, he has two lots of the same stock—100 shares which he has held for more than 6 months and 100 shares which he has held for not more than 6 months—a peculiar situation comes about. If the trader exercises the Put, he must be careful which lot of stock he delivers. If he delivers the lot, which has been held for more than 6 months at the time he purchased the Put, he will have a short-term gain on the exercise of the Put; and if within 6 months of exercising the Put he sells the other lot, he will have a short-term gain on the latter sale, also.

This unusual situation comes about as follows:

The purchase of the Put is treated as the making of a short-sale for the reason that, at the time of the purchase, one lot of stock has been held for not more than 6 months.

The first of the two consequences mentioned above is that any gain on the closing of a short-sale to which the special rule applies is to be treated as a short-term gain. The second consequence is that the holding period on the stock which has been held for not more than 6 months when the Put was purchased, starts on the day the short-sale was closed (i.e., the day the Put was exercised). Therefore, if the latter lot is sold within 6 months of the date of the exercise of the Put, the gain will be short term.

If the trader had exercised the Put by delivering the lot which had been held for not more than 6 months at the time of the purchase of the Put, the gain on the closing of the short-sale would still be short term but he would be left with the lot that had been held for more than 6 months; this lot would not have lost its holding period, and when it was later sold, the gain would be long-term.

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