Locking In a Gain

“Years ago, I read one of your books that explained the Rule Of 72. This was one of the most important pieces of knowledge I ever acquired. It put me on the road to understand money and I am proud to say that I am retired at 55 and love it. I would like to ask some advice on another matter. I recently retired and have about 1000 shares of the company that I worked for. It recently hit an all time high of 57. I am afraid of a big market correction, but want to wait until January 1999 because of heavy taxes. The stock more than doubled in price and is considered a cyclical. What is the best way to hedge against a big drop in price until January of 1999?” -Bruce Kern

It’s hard for me to see how the Rule of 72 was important to your success, but I’ll take credit for anything. (That reduction in crime rates? My doing.) So I guess the first thing I’d better do is reiterate for other readers this handy rule of thumb: To determine how long it takes money to double at a given rate of growth, divide that rate into 72. If you own something that earns 4% after tax, it will take about 18 years to double – 72 divided by 4. At 9%, about 8 years – 72 divided by 9. At 24%, about 3 years – 72 divided by 24.

The Rule of 72 is easy. The 24% return – that’s the part I wish I could take credit for. (And of course the Rule of 72 is not original with me; it was the discovery of some 72-year-old Babylonian investment banker.)

As to your 1,000 shares of stock, I wonder whether you won’t have the same feeling early in 1999 – wanting to push the taxable sale into January 2000. But taking your question at face value, you have a few choices.

SHORT AGAINST THE BOX – NO MORE

The old way to do this was called shorting-against-the-box. You’d sell short 1000 shares of GE, say, rather than sell your 1,000 shares of GE, and thus not expose the sale to tax. You’d be long and short 1,000 shares at the same time, so have zero exposure to profit or loss; yet you would not be deemed to have sold your stock. This venerable old loophole has at long last been retired by the latest tax law.

At least for most of us.

If you own 100,000 shares of the stock, or a million, call an investment bank and ask about “collars” and other such tax- and disclosure-avoidance devices that may still be legal but shouldn’t be. To us small fry, these opportunities are not available.

BUY PUTS

You can buy 10 puts on your stock (each put represents an option to sell 100 shares) so that if it goes down, you’ll profit at least partially, if not equally, from the decline. (Indeed, buy 50 puts and you’ll be thrilled by even the slightest dip.) But buying puts stops the clock on your holding period (as shorting-against-the-box also did), so it’s not a way to protect yourself while waiting for a short-term gain to go long-term – it will never go long term, if it hasn’t already, so long as you own puts on it.

Mainly, buying puts is not cheap. You pay a price for this protection.

WRITE CALLS

You can sell (“write”) 10 covered calls against your stock, getting an immediate, fully taxable “premium” for giving someone the right to buy it from you. (They’re “covered” calls because your exposure is covered by ownership of the underlying shares. You can also write naked calls on a stock you don’t own – but please call a good psychiatrist before doing so.)

Say you write the January 60s for $3½ — $3,500. You are giving the buyer the right to buy your stock at 60 — which you won’t mind too much because it’s only 57! — any time until mid-January. If the calls expire worthless, because your $57 stock never exceeds 60, so no one wanted to exercise them, you get to keep the $3,500 (less ordinary income tax) to cushion any drop in the stock.

If your stock should be 43 in January, you won’t be out $14,000 for having held on ($43,000 versus the $57,000 you could have had today), but more like $11,500.

Then again, if the stock should surprise you and be 95 in January, your stock would have been called away at 60, leaving with you with $63,500 before tax instead of $95,000.

Writing covered calls works best with a stock you expect to be weak for a while but want to hold on to for the long run. (Even then it is tough to win in the long run, because every once in a while, you get blindsided by a huge drop or increase in the stock that you didn’t expect. Either way — huge drop, huge spike — you’re left feeling rueful.)

SHORT SOME SIMILAR STOCK

You can’t short against the box, but you can short some stock you think is likely to perform similarly to your own. Notice how “the oils” or “the semiconductors” often seem to follow similar paths? Well, maybe you could short $57,000 worth of some stock very much like your own. But I wouldn’t, for two reasons.

First, if you “win,” you still lose. Let’s say both stocks drop 20% by January. So your lost profit on the original shares is offset by your profit on the short-sale. You might think the only costs are the commissions; but since all gains on short sales are treated as short-term, even if you have been short 40 years, you could wind up converting what would have been lightly taxed long-term gains on the first stock into fully-taxed short-term gains from the short sale.

Second, you could get really hosed. Say you owned Ford and shorted GM, or vice versa, and then one of them wound up doing very well at the expense of the other (or just wound up doing very well while the other did poorly). Your $57 stock could go down just as you feared, but the similar stock your shorted might go up. So now you’ve lost some of your profit on the first stock and have a loss on the second. Ugh.

SO YOU KNOW WHAT?

If you think the stock is overpriced and don’t want to risk its going down, one not-terrible strategy, especially if it’s already a long-term capital gain, is to sell it and pay the tax.

Tomorrow: Short-Sale Mechanics
Then: The Short Squeeze