How to Trade Index Spreads with Tax Advantage

Preparations for paying income related taxes come with the start of a New Year. In this article, we’ll show how investors can potentially reduce their income taxes for broad based index spread trades and introduce methodologies and tools for trading broad based index spreads.

Section 1256 Contracts Marked to Market

Trading broad-based index options for taxable accounts can have some favorable consequences when paying federal income taxes. The IRS has a provision known as a Section 1256 Contracts Marked to Market. A section 1256 contract is any:

1. Regulated futures contract,
2. Foreign currency contract,
3. Non-equity option,
4. Dealer equity option,
5. Dealer securities futures contract.

Broad-based Index Options

The third item in this list, non-equity option, is of interest for trading index options. The IRS defines a non-equity option as “any listed option that is not an equity option.” According to the IRS, non-stock options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (ten or more). Standard and Poor’s 500 index is one example of a broad-based stock index.

60/40 Rule

Generally, capital gains from stock or stock option investments held less than one year are considered short-term and those held longer than one year are considered long-term. However, according to the IRS, under the marked to market system, 60% of a capital gain or loss may be treated as a long-term capital gain or loss and 40% may be treated as a short-term capital gain or loss, even if the position was held for less than a year. The ramification of this rule is that capital gains or losses considered to be long-term have lower marginal tax rates than short-term capital gains or losses, and index options on broad-based indexes qualifying under the 60/40 rule have a more favorable tax treatment over options on equities considered short-term investments.

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Example

For example, for a short-term capital gain with a marginal tax rate of 35%, the marginal taxes on a $1,000 capital gain would be $350 and for a long-term capital gain with a marginal tax rate of 15%, the marginal taxes on $1,000 would be $150. Using the 60/40 rule, 60% of the capital gain, $600, would be taxed at 15% and 40% of the capital gain, $400, would be taxed at 35%, so the taxes paid under the 60/40 rule would be $90 for the portion considered long-term and $140 for the portion considered short-term for a total of $230 which is $120 less than if the total capital gain were considered short-term. The composite marginal tax rate for this example of the 60/40 rule is 23%, 12% less than the 35% rate for short-term capital gains and represents paying 34% less in income taxes.

Actual Broad-Based Index Spread Trade Example

To take advantage of trading option spreads for broad-based indexes investors must first make a profit. To aid investors in successfully trading broad-based index spreads, an actual broad-based index spread successfully traded is presented.

Trade Details

A bull-put credit spread was entered for PowerOptionsApplied’s Chromium TradeFolio™ on 8/5/2011 with the initial position and representative market bid/ask prices as shown below:

Initial Position Entered on 8/5/2011
Action	Option	Bid	Ask
Buy-to-Open	$SPX 2011 Aug 1070 Put	$5.65	$7.15
Sell-to-Open	$SPX 2011 Aug 1095 Put	$7.20	$8.80

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Market Return

Entering the position at market prices would have yielded a net credit of $0.05 calculated as $7.20-$7.15 for a potential return of 0.2%. The potential return is calculated as: [net credit*100%/(capital requirement – net credit)] = [$0.05*100%/(1095-1070) – $0.05]. With the capital requirement per share calculated as the difference between the strike prices for the options.

Midpoint Pricing

Option trades can often be filled at the midway point between the bid and ask prices with the calculation for the midway point for buying the $SPX 2011 Aug 1070 Put option calculated as $5.65+($7.15-$5.65)/2 = $5.65 + $0.75 or $6.40. Similarly, the midway point for selling the $SPX 2011 Aug 1095 Put option can be calculated as $7.20+($8.80-$7.20)/2 = $8.00.

The spread between the midpoints is then calculated as $8.0 – $6.4 which equals $1.60 with the potential return calculated as [$1.60*100%/(1095-1070) – $1.60] or 6.8%.

The trade was entered for a net credit of $1.50 and the trade was executed for a net credit of $2.20. This is a significant increase in net credit over the midpoint pricing and is atypical. The reason for the significant increase in net credit is a result of the price of the $SPX dropping significantly between the time the trade was selected and the time the trade was placed. The $2.20 net credit represented a potential return of 9.6%.

By attempting to enter a spread position using midpoint pricing, the potential return was significantly increased to 9.6% from the potential market-based return of 0.2%. The 0.2% potential return can be realized simply by entering a market order, but to get a position with the midpoint return of 6.8% requires entering the position with a net limit order.

As you can see, performing the vast array of the midpoint calculations is a lot of work. Granted some brokers provide midpoint pricing for each option, but not for the midpoint spread between the midpoint prices. PowerOptions new Mid-Point Spread Chain tool not only provides the midpoint pricing needed for spread trading but also provides other important information such as % out-of-the-money, potential return, annualized potential return and probability of success.

Mid-Point Spread Chain
A partial screen capture from the PowerOptions Mid-Point Spread Chain unrelated to the position mentioned above is shown below:

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For brevity, the call option spreads have been omitted. The parameters used for the screen capture above were:

• Spread width : 25
• Min Credit: greater than 0
• % Out Money Range: greater than 0
• Min % Return: greater than 5%
• % Probability Range: greater than 90%

As an example, the 1130/1155 bull-put credit spread has midpoint prices for the bid/ask of $2.22 and $3.70, respectively. The spread between the midpoints is $1.48 ($3.70-$2.22). The $1.48 represents a good starting point for the limit price for entering the position. As shown in the screen shot above, the short strike for the 1155 put option is 8.3% out-of-the-money, the potential return is 6.3%, the annualized potential return is 99.9% and the probability the position expires out-of-the-money is 96.5%.

PowerOptions’ Mid-Point Spread Chain takes care of the cumbersome calculations needed for entering spread trades and also for management of spread trades as shown in the following paragraphs.

Rolling a Position in Trouble

On 8/10/2011, the price of $SPX had dropped significantly and the August spread trade entered on 8/5/2011 for Chromium was in trouble as shown below:

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Out-of-the-money spread trades can typically be rolled for a net credit, but once the trade transitions to in-the-money, rolling the position for a net credit is less likely. In order to prevent the position from going in-the-money, the August bull-put credit spread was rolled to a September bull-put credit with a lower short strike price. PowerOptions’ Mid-Point Spread Chain tool was used to evaluate and find the new position for potentially rolling as shown below:

Rolling Position on 8/10/2011
Action	Option	Bid	Ask	Mid-Point	Spread
Sell to Close	$SPX 2011 Aug 1070 Put	$9.85	$10.95	$10.40
Buy To Close	$SPX 2011 Aug 1095 Put	$12.45	$16.45	$14.45	$4.05
Buy to Open	$SPX 2011 Sep Q 1050 Put	$23.55	$26.75	$25.15
Sell To Open	$SPX 2011 Sep Q 1075 Put	$28.25	$32.25	$30.25	$5.10

To close the August spread required a net debit of $4.05 and entering the September spread position has the potential to generate a net credit of $5.10 with the combination of the two resulting in a potential net credit for rolling of $1.05 ($5.10-$4.05).

The position was entered at a net credit of $1.00 which was slightly lower than the midpoint calculation of $1.05.

Rolling a Position Again

The Chromium position was once again in trouble on 9/22/2011 as shown below:

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Using PowerOptions’ Mid-Point Spread Chain tool, a candidate position for rolling was found. The September bull-put was rolled to an October bull-put for a net credit as shown below:

Rolling Position on 9/22/2011
Action	Option	Bid	Ask	Mid-Point	Spread
Sell to Close	$SPX 2011 Sep Q 1050 Put	$7.15	$9.15	$8.15
Buy To Close	$SPX 2011 Sep Q 1075 Put	$11.75	$13.75	$12.75	$4.60
Buy to Open	$SPX 2011 Oct 1030 Put	$19.00	$21.30	$20.15
Sell To Open	$SPX 2011 Oct 1055 Put	$24.70	$26.30	$25.50	$5.35

To close the September spread required a net debit of $4.60 and the October spread position had a potential net credit of $5.35 representing a potential net credit for rolling of $0.75. The order was placed with a net credit limit of $0.70 slightly lower than the midpoint value of $0.75 and was executed for $0.70.

Rolling Troubled Position for the Last Time

On 10/3/2011, the Chromium position was once again in trouble as shown below:

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Using PowerOptions’ Mid-Point Spread Chain tool, a candidate position rolling was found. The October bull-put was rolled to a December bull-put for a net credit as shown below:

Rolling Position on 10/3/2011
Action	Option	Bid	Ask	Mid-Point	Spread
Sell to Close	$SPX 2011 Oct 1030 Put	$17.17	$18.37	$17.77
Buy To Close	$SPX 2011 Oct 1055 Put	$23.18	$24.78	$23.98	$6.21
Buy to Open	$SPX 2011 Dec 1020 Put	$46.19	$47.79	$46.99
Sell To Open	$SPX 2011 Dec 1045 Put	$53.25	$55.25	$54.25	$7.26

A suitable candidate for rolling to November was not found which is why the December position was selected.

To close the October spread required a net debit of $6.21 and to enter the December spread required a net credit of $7.26 based upon midpoint pricing with a resulting potential net credit of $1.05 ($7.26-$6.21). The roll order was placed with a net credit of $1.00 which was slightly lower than the midpoint calculation and was executed for a net credit of $1.05.

Trading Success

On December 17, 2011, the December put options expired worthless and the combination of the series of trades yielded a total net credit of $4.95 ($2.20+$1.00+$0.70+$1.05) for a return of 21.7% (not including brokerage fees and commissions). The return was calculated as $4.95*100%/($25-$2.2).

From start to finish, the position required 134 days to generate the 21.7% return which represented a 4.9% monthly return and a 59.1% annualized return.

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Summary

Successful trading of option spreads for broad-based indexes can result in significant reduction in income taxes paid. Additionally, a significant amount of analysis is required for initial entry and management of spread trades using exchange bid/ask prices. The amount of effort required for spread trading can be significantly reduced through the use of tools such as PowerOptions’ Mid-Point Spread Chain which uses midpoint pricing for analysis, as option trades can often be executed at the midpoint between bid/ask.

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Disclaimer

The information provided in this article is for informational purposes only. Power Financial Group, Inc. makes no claims as to the accuracy of the tax-related information included in this article and you should consult your tax advisor for more details.