Investors rarely think about their tax bill while they're buying – they conveniently forget all about the IRS until the end of the year – or even worse, they ignore taxes entirely until the eve of April 15th.
But there's a simple way to DECREASE your tax bill, INCREASE your gains AND do so without added complexity or volatility in your portfolio.
So why doesn't everyone use this secret?
Well, like any loophole, most people just have no idea that this simple way to avoid taxes even exists.
And ultimately, most people aren't interested in this type of safe and steady investment. They're looking for high-risk, high reward investments that also tend to have high tax bills.
The secret? In most cases, you should avoid trading options on individual stocks, and use ETF options instead.
Before I get started explaining why, I realize that such a statement might seem bizarre. After all, if you've traded options before, it's likely that you traded them on a single stock. And it's easy to see why it's tempting to stick to stocks.
Individual stocks tend to move more quickly and dramatically than ETFs, for the simple reason that they're generally smaller and are more price-sensitive.
Think about it. even a huge multi-national corporation like Exxon-Mobil (NYSE: XOM) is much more volatile than the S&P 500.
Since options use leverage, your potential for gains is much greater with individual stocks.
But so is your potential for massive losses.
ETF's prices present a slower moving target – which means the gains are easier to capture, and the losses easier to avoid.
I don't know about you, but as I said before – I'm not interested in trading options for the "thrill" of it.
I trade options to make money.
And I've been doing so successfully for over a decade. I don't like big risks, and I don't like trying to "guess" when a hot stock will move, or where.
I prefer hunting sloths to chasing down wolves. Even an especially unhappy sloth can't hurt us too bad – but a wolf can turn on you in a second if you make a bad call.
Okay, so if volatility was the only reason to avoid individual stocks, that would be a good enough reason for me.
But the benefits of focusing on ETFs don't stop there.
Because there are huge tax benefits to trading options on ETFs vs. individual stocks.
With very few exceptions, ETF options are referred to as Section 1256 Assets and receive preferential tax treatment. Unlike individual stock holdings, which you need to hold for a year in order to benefit from the "long-term capital gains" tax, all ETF options are taxed a little differently. Essentially, 40% of ETF options gains and losses are taxed at the short-term capital gain (or loss) and 60% of the gains are taxed at the long-term capital gain (or loss), irrespective of the holding period.
In other words, even if you hold a non-equity option for only a single day, 60% of your gain is considered to be a long-term gain. With individual stocks, you would have to hold the option for a full year to enjoy this benefit. If you are in the 35% tax bracket, that means that these gains will be taxed at only 23% (40% of gains taxed at 35%, 60% of gains taxed at 15%).
For example, if an investor had $1,000 of Section 1256 gain, $600 would be taxed at the 15% long-term rate (a tax of $90), and $400 would be taxed at the 35% short-term rate ($140), for a total tax of $230 (23% of the $1,000 Section 1256 profit).
This preferential treatment is only for non-equity ETF options such as listed options on broad-based indexes. It does not apply to the underlying ETF itself – and it doesn't apply to individual stock options or shares.
- What this means is that you'd need to be 12% better at trading single-stock options than ETF options in order to make up the difference in taxes.
- But as I already noted, it's trickier to trade single-stock options – so when you trade them, the deck is significantly stacked against you.
It should be crystal clear that you should only ever trade options on ETFs.
Besides, today there are enough ETFs out there to benefit from the same trends you would want to replicate in any individual stock. If you're looking to make money with rising or falling gold prices for instance, you don't need to trade options on Barrick Gold (NYSE: ABX). You can use any number of highly liquid, lower taxed, and less volatile ETFs like the SPDR Gold Trust (NYSE:GLD).
Options don't need to be difficult, risky or complicated in order to be profitable – and by following the simple rules I've discussed in The Daily Profit, The Strike Price and in Options Advantage you can successfully use options to add healthy amounts of income to your nest-egg, month after month.