Tax Reform Points to This Trade
Tax reform is on the minds of analysts and traders. Proposed changes to the tax code are believed to be the most significant changes since 1986. Next year, corporate tax rates could fall sharply and that is forcing analysts and traders to reassess their outlook for prices.
In addition to corporate taxes, the proposed reforms also lower personal tax rates. This is the aspect of reform that traders may not be emphasizing in their strategies for the rest of the year.
Lower Tax Rates Could Drive Decisions
Many financial theories about how markets work start with assumptions that are common to the field of economics. In economics, many theories are based on the existence of a homo economicus, or economic man.
Homo economicus assumes that humans as consistently rational and narrowly self interested in pursuit of their personal goals. This theory assumes individuals always behave rationally in the way that will maximize their long term wealth.
It’s a useful theory but in the stock market, we know that individuals can act irrationally. Often, small facts will create largely irrational responses. For example, investors in dividend stocks will hold onto losses and justify their behavior with the belief that the dividend provides income and losses aren’t important.
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In economic terms, the losses in the stock price are important. But, studies demonstrate that individuals behave irrationally. One recent study summarized the problem with the statement that “Dividends are not free money (though lots of investors seem to think they are).”
Taxes are another area where irrational beliefs can influence actions. Many investors will delay selling, for example, to generate a tax benefit based on holding periods. This applies to investors around the world.
With tax reform, many investors will be assessing their personal tax situation for this year and next. Although the amounts may be relatively small, the decisions may be market moving and significant.
This is because there is a short amount of time to act and fearing they may miss an opportunity, many investors could act. With lower tax rates next year, gains may be deferred and losses may be accelerated. This makes stocks with long term losses potential sell candidates.
A Drug Company With a Multiyear Down Trend
Among the companies where long term investors face potential losses is Valeant Pharmaceuticals International, Inc. (NYSE: VRX). The chart below shows the extent of the down trend.
Valeant is more than 90% below its 2015 high. Investors who bought the stock prior to this year are almost certain to show a loss on their position. That makes this a prime candidate for tax loss selling in the next two weeks.
By selling now, an investor will be able to use a taxable loss to offset any taxable gains they incurred in the previous year. That will lower their income for this year. By waiting until next year, the loss will still be available to offset gains but with lower rates, the value of the benefit declines.
Another reason investors may decide to recognize capital losses this year rather than in the future is the uncertainty associated with losses. This year has been an up year in the stock market and many investors are likely to have gains in their accounts.
Those are real gains, and taxes will be due on gains generated in a taxable account. Investors have no way to know what next year holds. They may have gains, or they may not. This uncertainty could be adding to the appeal of recognizing losses, where they are available, this year.
The probability of tax selling sets up a potential trade in Valeant. The short term chart below shows that the stock has been moving higher.
Now, with the ability to maximize the after tax value of a loss, an investor may sell the stock. They could always buy the stock back in about a month to comply with tax rules for what is known as “wash sales” or an effort to wash an account with losses without changing the underlying risks.
Or, investors can use options to create their new position in the stock while selling the shares for a tax loss. Either way, the chart shows there is potential resistance near $23 in the stock.
The expected short term down trend in the stock creates a trading opportunity.
To benefit from weakness, an investor could buy put options. But, as the chart shows, VRX has been in a downtrend over the past few days and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in VRX
For VRX, we have a number of options available. Short term options allow us to trade frequently and potentially our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a January 5 $23 call for about $0.40 and buy a January 5 $24 call for about $0.20. This trade generates a credit of $0.20, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $20. The credit received when the trade is opened, $20 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $80. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($20).
This trade offers a return of about 25% for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if VRX is below $23 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $80 for this trade in VRX.
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