Using the collar strategy to avoid paying capital gains taxes can be an effective strategy depending on the time horizon of the stock options, the particular stock options chosen and the performance of the underlying stock. In other words, so long as the investor holds onto the appropriate long position, and ‘collars’ by writing call options and purchasing put options with expiration after the end of the fiscal year, the strategy could postpone paying of income taxes to a subsequent year.
To illustrate further, since the collar strategy can yield profit on the difference between the cost of the put option and the call premium, the possible exercising of the options is of importance. Even if the expiration date is past the end of tax year, the put option could be exercise before then potentially leading to taxable income. Moreover, a positive difference incurred from an early closing of a call option and exercising of the put may yield taxable income.
To effectively employ a collar, a few important steps can be considered.1)) Hold a long position that is estimated to remain flat or decline significantly in share price 2) ensure the company is also tradable through stock options and 3) study the options available in terms of price, premium and expiration date. All being well, the selection of the collar strategy will be both financial fruitful and a tax deferral technique.
An example of collar options strategy to avoid paying taxes is as follows. Investor Y owns 1000 shares of ABC corporation currently priced at $86.00/share. ABC corporation is currently priced above the purchase price paid by the investor. To avoid selling and paying capital gains taxes, investor Y writes 10 call options for ABC corporation with a strike price of $95.00 and purchases 10 put options for the same company with a strike price of $75.00.
If the price of ABC rises, the underlying stock value will yield a non-taxable gain if it is not sold before the end of the tax year. However, the premium of the call option will be lost if the stock price rises above the strike price in addition to the costs of the put option. The difference between the underlying stock gain and the cost of the options will therefore determine any profit or loss. In the case of a capital loss, this amount may be deductible from taxable income if the options are exercised before the end of the tax year.
Should the price of the underlying stock remain flat or decline below the purchase price of the underlying stock, and the put option’s strike price, the premium from the call option plus the gain from the difference of the put option’s strike price minus the current price after costs can serve as a tax hedge against holding onto the underlying position to postpone capital gains tax.