Hedging Strategies for Protecting Appreciation in Securities and Portfolios

Miller, Mark A.
August 2002
Journal of Financial Planning;Aug2002, Vol. 15 Issue 8, p64
Academic Journal
This article discusses hedging strategies which can be used for protecting appreciation in securities and portfolios. There are as many possible hedging strategies as the creative mind can structure. Therein lies the legitimate concern that hedging strategies can be misused. Furthermore, financial planners might fear that merely suggesting the consideration of a hedging strategy could tarnish their reputation. The short-sale strategy involves selling stock borrowed from a third party. If the stock declines in value, the stock is purchased on the open market at a lower price than the initial sales price. While the purchase of a put option permits investors to limit the downside risk of a stock while retaining the opportunity for stock appreciation. A put option permits the purchaser of the put option to sell a certain number of shares at a pre-determined time frame. Taxes are a key factor in evaluating how to most efficiently minimize risk in taxable portfolios. With a sale, the tax liability is a straightforward computation, using appropriate short-term and long-term capital gains rates, both state and federal, offset by available capital losses. With hedging strategies, the transaction costs, especially taxes, are less quantifiable because the final selling prices are not known because the final transaction price is not fixed. For hedging strategies, two primary rules govern taxation, the constructive sales rules and the straddle rules. The constructive rule governs whether initiation of the hedge is construed to be a sale of the hedged security and therefore a taxable event. The straddle rules govern the tax aspects of closing the hedge. Financial planners may see opportunities for hedging strategies that investment advisors and trustees may not be aware of.


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