How Will the Fiscal Cliff Change Year-End Options Strategies?

Michael Fowlkes, InvestorsObserver

While tax season is not for another 4 months, December is the time to start your planning. As investors, we have to take a serious look at our current holdings, and come up with a plan that will benefit us the most when it comes time to file our 2012 taxes.

In years past, one of the most used strategies was to get out of some of your losing trades, and hold onto to those stocks that have enjoyed a good year. This strategy has worked well in the past, but this year the game has changed, and if you are not aware of the tax implications of your actions between now and the end of the year, it could have serious consequences.

What is different this year is the looming fiscal cliff. The fiscal cliff is a combination of events that are set to occur at the same time, one of which is the automatic ending of the Bush-era tax cuts. What this means is that unless Congress acts to extend the tax cuts, we are going to see higher capital gains tax next year.

While President Clinton was in office, investors faced paying 20% on their capital gains and dividends. When the Bush tax cuts were passed in 2003, the tax rates on capital gains were lowered to 15%, but the law had a life span of 10 years, and those 10 years are up.

Republicans would love to see the Bush-era tax cuts become permanent, but President Obama has other ideas. During his candidacy, Obama ran on raising the capital gains tax back up to 20% on individuals that make over $200,000 and couples with a combined income in excess of $250,000.

While the Republicans in Congress will definitely try to work a deal where capital gains remain at their current 15%, it remains a distinct possibility that President Obama will get his way and we will see the tax move back to 20%.

What this means is that the typical December strategies are out the window. Instead of holding onto winners and selling your losers, a lot of investors are going to want to do just the opposite. Why hold onto winning stocks until next year if it is going to cost you an extra 5% in taxes? Likewise, since you will have to pay more next year in capital gains, it would make sense to keep your losing trades in your portfolio and take the losses next year instead.

How real is the possibility that we are going to see higher capital gains? Considering how divided Congress has been on the issue, it is very real, and we are already seeing moves by big companies that illustrate just how real of a possibility it is.

A lot of companies such as Wal-Mart (WMT) and Las Vegas Sands (LVS) have announced large, one-time dividends to be paid out before the end of the year. In addition, Wal-Mart announced that it is moving up its next regular dividend payment to occur during the last week of December as opposed to the first week in January.

If these major corporations are making changes in order to prepare for the possibility of higher capital gains, chances are good that we will start to see a lot of big fund managers taking steps as well. Any stock that has been on a heater over the recent years is a likely target for selling before the end of the year, and this is something that we can take advantage of.

Consider the biotech ETF iShares Nasdaq Biotechnology (IBB). This ETF has outperformed the S&P by nearly 300% over the past year, putting some big gains in a lot of investors’ portfolios. Since January, the ETF is up 32.5%, and it is up 48% since the start of 2011. What this tells us is that there are a lot of investors out there looking at big gains in the stock, and we expect to see a decent amount of profit taking before the end of the year.

So knowing this, how can we take advantage of the situation? The easiest way is to set up a bearish hedged trade on the stock. We want to go bearish because we believe the profit taking will take place; but we want to hedge our bet just in case Congress does decide to work together to keep the capital gains tax rate at its current level and we do not see the sell off that we are expecting.

A nice hedged trade on IBB would be the January 145/150 bear call credit spread. In this trade, you would sell the January 145 calls while buying the same number of January 150 calls for a credit of 40 cents. This trade has a target return of 9%, which is 67% on an annualized basis (for comparison purposes only). With IBB currently trading at $138.64, this trade has 4.5% downside protection.

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Tags: Options, Market, Fiscal Cliff, Taxes, Politics, Congress, ETFs, IBB, iShares NASDAQ Biotechnology Index Fund