Insider Hint: Long-Term Gains in Declining Markets
There is no way, except for the one I shall describe, that one can make a long-term gain in a declining market. If one has a profit on a short sale, that profit is a short-term gain regardless of how long one is “short” the stock.
If, in anticipation of a decline, one sold “short” at 50 and stayed short for six months, or even a year, and then covered at a profit, that profit would be a short-term gain. The only way that a long-term profit can be made in a falling market is through the purchase of a Put option good for more than six months and the sale of the contract itself after it has been held over six months if the decline in the stock in question is great enough to show a profit. As an example:
A taxpayer buys a put option at 50, good for six months and 10 days, for $500. After he has owned the option for six months and a day, the stock is selling at 30. By selling the actual contract to someone (and my firm—and others as well—will always be willing to buy an option from the holder which shows him a profit, if it is in our hands 24 hours before it expires) he will be selling a contract which he has held for more than six months and the profit will be a long-term capital gain.
The option-dealer will exercise the contract for his account and will sell the corresponding stock in the market (in the case of the call), or will buy the stock in the market (in the case of a put). The purchase price, which the option-dealer will pay, will be equal to the net proceeds of the dealer’s transactions less two regular stock exchange commissions and any applicable tax.
You can, however, very easily spoil your opportunity to make such a long-term gain by handling such a situation wrongly; then, instead of creating a long-term gain taxable at 25 percent, you might end up paying a tax of 60, 70, or 80 percent according to your tax bracket.
Suppose, instead of selling the put contract for the difference between the put price of 50 and the market price of 30, you bought the 100 shares of stock in the market at 30 and exercised your option at 50. Your profit would be the same as in the first operation, but your tax would be a short-term gain. The reason? Your tax is based not on the duration of the option but on the length of time you hold the stock in question, and in this case you would have held the stock and sold it through your Put option all in one day. This makes the difference between your paying a tax of 25 percent or one of 60, 70, or 80 percent, according to the tax bracket you are in.
Taxes are inevitable, but as we have shown, there can be limits imposed on them according to how one handles his investments. It is important to take this into account when attempting to profit in a declining market.
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