Gyroscopic Investing

I've been discussing this on Bogleheads recently and armed with info from that thread, along with the unique characteristics of the PP, I believe I have a strategy that will only work for PP investors.

The goal is to lawfully manufacture a "tax loss" while maintaining market neutrality within the PP. The theory is that one asset creates a taxable investment loss while another asset creates an equal gain that can be deferred into the future (and taxed at a lower rate).

I currently have a basic premise to share and discuss. I need to research further specifics and estimate the loss due to overhead involved.

Assume a model $100k portfolio with $25k of each of the 4 assets.

Step 1) Sell $5k of Stocks. At this point there are two possibilities. Stocks increase in value, in which case you lose because you exited $5k from the stock position. Or stocks decrease in value, and you "win" because you removed a portion of money that would have incurred a loss.

Step 2) Purchase $5k worth of Options to Buy the Stock at the current stock price, or higher. In this case, if stocks increase in price, you win because you have the option to buy them at a lower price. This means if Stocks go up, your move of selling the $5k loses money, but your options to buy increase in money, netting each other out to zero (other than the loss of overhead to carry out the strategy).

If stocks increase in value, then exercise the Options to buy. I believe this does not incur a taxable event until you actually sell the newly purchased stocks, although I may be mistaken. In this way, you could defer the taxable gain until you decided to sell the new stocks you bought at below market value. If you sold the options, then the tax-hit would occur immediately because you profited off the option sale. However if you exercise the option, I believe you can defer the tax hit since you didn't realize a gain until you sold the stock.

Imagine you do this in an IRA and a taxable account. Within the IRA, you sell $5k worth of stocks you were holding, and move the $5k into "cash." Then you take $5k worth of cash that you had in taxable accounts to buy options as described above. On a net-basis, your cash position was neutral because you lost cash in taxable (to buy the options) but you gained an equal amount of cash in the IRA (from the sale of your stocks).

This would allow you to get a tax-break if Stocks go down in price, and your options become worthless. Then you realize a loss on the options held in taxable. If stocks go up, you exercise the options in taxable, and defer the tax-hit until you sell the stocks.

This strategy alone would only have a chance of working, because if stocks go up, then there's no tax-hit, because you "lost" money on a phantom basis within the IRA by forgoing the gains that the $5k of stocks could have earned. So how do we guarantee a manufactured tax loss?

Perform the same strategy but with long term bonds, using options to buy TLT. Theoretically either Stocks or TLT will go up, but not both at the same time, over the time line of one year. It's possible both could go down, and that's great because now you have an even bigger manufactured tax-hit in taxable if both sets of options become valueless. I think the opposite of both going up together is highly unusual and unlikely. If you think that's possible, we can do this a third time with GLD as well and at least one should go down. If they all go up, then terrific your PP is doing amazing and you shouldn't worry about not getting a tax-break.

Obviously I am glossing over several important details that I am ignorant and unclear of. In order to exercise the options to buy a Stocks ETF (or TLT), you would obviously need more money in taxable in order to physically purchase the shares at the lower than market value. This would require additional PP manipulation because buying a ton of shares of stocks would offset the balance unless you transferred other stocks you hold into GLD/TLT/Cash at the same time to retain the proper balance.

Also, I'm not good enough with Black Scholes to figure out exactly how much the value of options needs to be to perform this strategy. In other words, using my example, if I "sell" $5k worth of stocks within the IRA to hold cash, and I am $5k short of stocks from my target allocation, how much do I need to spend on Options to recreate an appropriate counter balance?

Suppose the Stock Index ETF traded at $100 per share at the time I partake in this. I think I would want options to buy 50 shares at $100 while I sell $5k worth. The cost of those options is going to depend on lots of factors. Let's imagine they cost $500. Then the most I can "lose" on a manufacturered basis is $500 if the options drop to zero. I'd actually need to buy $5k worth of Options to obtain a $5k manufactured tax loss if they become valueless. $5k worth of options might allow me to buy $50k worth of stock at the strike price. That would mean I would have to sell $50k worth of stocks at the start of this maneuver in order to maintain market neutrality regardless of outcome.

If I sell $50k worth of stocks to buy $5k worth of options, then where does the other $45k go while waiting to see if I should exercise the options? I imagine it can and should sit in cash because then it's earning interest, and is also available to exercise the options if the stock price goes up. This seems like it must screw with the PP if I am holding substantially less stocks than I should, even if I am holding the option to buy at the price that I sold at.

In my situation, I can save about $1500 per year, for the next few years, if I can manufacture $3k worth of tax losses each year. It's really not worth it from a money perspective. I'm more interested in doing so just for the sake of doing it because it would be cool to come up with a legal guaranteed strategy to create free money, even on a small basis. It would also be cool if one would need to be a PP investor to make it work. i.e. this won't work unless you invest in both LTTs and Stocks (and maybe gold is we do the trifecta option strategy).

Interesting.  Does the wash sale rule apply to options on the underlying security?

I'm quite sure the wash-sale rule prevents the ability to use options contracts and IRA's to effectively do the same thing.

You can tax-loss harvest a TSM index fund ETF and immediately repurchase the SP500 ETF index fund the same day, generate a tax-loss that is legit, and not a wash sale.

If using an options strategy as I described in my first post, we could just have options written on "substantially dissimilar" ETFs such as TSM and SP500. If it's legit to do it with the ETF, then it's legit to do with options.

The reality is that they "only" track each other with 98% correlation or there abouts, so there is risk, but the risk is very small.

TripleB wrote: You can tax-loss harvest a TSM index fund ETF and immediately repurchase the SP500 ETF index fund the same day, generate a tax-loss that is legit, and not a wash sale.

If using an options strategy as I described in my first post, we could just have options written on "substantially dissimilar" ETFs such as TSM and SP500. If it's legit to do it with the ETF, then it's legit to do with options.

The reality is that they "only" track each other with 98% correlation or there abouts, so there is risk, but the risk is very small.

Have you found an authoritative "dissimilar" citation with regards to these ETFs. I would love to do those swaps for tax purposes but swapping TSM for the SP500 would make me nervous. I have seen seeking alpha articles and the like, but I mean something with some meat behind it.

The law is so unclear I would hate to be caught on the wrong side.

What would be the worst case scenario if you were audited and the IRS made a determination that your loss harvest will not be allowed? The way I see it the worst case scenario is it would be the same as if you didn't sell it.

First off with the law unclear it is subject to interpretation.  Interpeting it to take a loss would not be criminal it would just be the way many people and the way the article in seeking alfa talks about a conserative interpetation.
So if the loss is not be allowed the costs would carried over to the replacement fund and when you sell that you would have a much smaller capital gain if you sell it at a profit in the future.

melveyr wrote: Have you found an authoritative "dissimilar" citation with regards to these ETFs. I would love to do those swaps for tax purposes but swapping TSM for the SP500 would make me nervous. I have seen seeking alpha articles and the like, but I mean something with some meat behind it.

The law is so unclear I would hate to be caught on the wrong side.

It's fine. Otherwise where do you cross the line? SP500 is 80% similar to TSM. If that's not good, how about a DJIA index fund that's 70% similar to TSM? TSM holds 5k stocks, SP500 holds 500, DJIA holds 30. Where does the line get drawn?

Unless the 2 indices are identical, or perhaps wholly identical whereby maybe 0.1% of them are different, then there's no worry. SP500 is only 80% th same as TSM, how can anyone argue they are similar? They have historically tracked each other with 95%+ correlation over short time frames, but if historical correlation is an indicator then selling Apple stock and buying Microsoft could be a wash sale if over the previous week they moved similarly.

Stop worrying so much about the government. They ARE out to get you, but at least for now there's some limitations on bad they can screw you over.