Potential Tax Implications and Settlement Issues

Before I go into the second part of this investment approach, I want to address tax considerations and discuss some details about option assignment and settlement.

Please keep in mind the following disclaimer: I am not a tax professional and while the following holds true for me, your personal situation may differ.

If a long-term long call is substituted for the married put, then favorable tax treatment may be available if done with cash-settled SPX options rather than SPY. The underlying index (SPX) cannot be purchased, so the synthetic equivalent must be used in lieu of the married put. I have read—but not confirmed—that some brokerages allow for cross-margining between SPY shares and SPX options. I wonder if said brokerages would cross-margin with other S&P 500 ETFs as well (e.g. IVV)?

Because I am not a tax specialist, I will quickly go over tax implications even though this deserves much more space. Options held longer than one year qualify for long-term capital gains (LTCG) treatment. The SPY ETF qualifies for LTCG treatment if held for more than one year (with the goal being to presumably hold and defer tax payment indefinitely). As suggested above, “favorable” means profit/loss on SPX options gets split into 60% LTCG and 40% short-term capital gains regardless of holding period. Holding for longer than one year would be ill-advised because I would still have to pay 40% short-term capital gains taxes on what would otherwise qualify as 100% LTCG (e.g. SPY options).

Assignment of shares can be a problem for retirement accounts. Consider what happens if I sell 10 Jul 300/290 bear call spreads on SPY for $3.00 each in my $100,000 IRA account. The most I can lose appears to be 10 * $100/contract * 10 contracts = $10,000, which is 10% of the initial account value. At expiration, suppose SPY trades at $291. I will be assigned on the short 290 calls forcing me to sell 1000 shares for $290,000. Because short positions are not allowed in IRAs, the position must be covered immediately. At Monday’s open, suppose I buy to cover for $291/share (assuming no price change from the close, which is not very realistic). I lose $1,000 of the $3,000 initially credited at trade inception on the assignment/cover, bank the profit, and move on.

“Not so fast, my friend.”

Being assigned on the short 290 calls brings 290 * $100/contract * 10 contracts = $290,000 into my account, but trades are not settled until two business days after execution. Being an IRA account, I must cover the short immediately with $291,000, which I do not have currently available since the sale has not yet settled.

Is this a problem?

I will discuss next time.