Many investors wish to keep their long-term stock positions for tax reasons, but this involves taking on the full risk involved. Managing this with futures can make sense.
It’s pretty easy to manage your positions in stocks just by moving in and out of them as needed. While stocks in general gain in value over time, there are times when the climate is better than others, ranging from a strong bull market which is easy to stay in, to major bear markets where we can see their value decline and have us both taking some big losses and wondering if we should be sticking around.
There’s nothing simpler than just holding our stocks in all weather, and waiting until we need the money to sell. Our expectation over the long run with this plan is a very good one, especially if we are in good stocks. If we are selecting our stocks rather than just letting a fund select them for us, we’re pretty much committed to rotating them, cutting the ones that aren’t doing well and replacing them with more promising ones, even though few investors show any sort of proper diligence with this.
Some might hold poorly performing ones for years, and while the long-term good expectation applies to stocks in general, this does not mean that this applies to each and every stock. There are some that haven’t even made it back to where they were 20 years ago, perhaps not even coming close, and some might not ever get back to previous levels.
We really don’t want to be committing long-term to stocks that end up stinking though, and while we will have to declare our profits as capital gains in the year that we liquidate them, it’s only the good ones that we need to worry about this with. If our returns have soured and even turned to losses with certain stocks, it’s just better to get out of them because the advantages here can greatly outweigh any tax implications, by paying the tax now instead of letting things ride and paying it later.
We do want some idea of how this all stacks up though, and investors tend to overestimate the tax benefits of holding on when it comes to underperforming stocks. If you are selling at a loss and the outlook remains grim, it’s always wise to take the loss, for both tax reasons and for the health of your portfolio as well, but people will still often hang on to these due to hoping they will come back.
Even if they do, we need to compare how much they will increase in value compared to selling and putting the money into a better stock, and this is the part that so many investors miss. Slower stocks need to be viewed this way as well, and the market averages do provide a good reference point for this, where we want to be beating these averages with all of our positions generally, and if we wish to look the other way with some, we at least need to have a reasonable expectation that they will pick it up enough to make sense of sticking with them, tax considerations or not.
Perhaps you are saving for retirement and expect to be in a lower tax bracket then, and wish to pay less tax on your capital gains. There is more to it than this though, as when you sell to buy something else, the value of your portfolio will be reduced by any tax paid relative to hanging on, so this makes the tax consequences a lot bigger deal.
If you hold $10,000 worth of capital gains and sell it, you have to cover the tax. You pay $2000 we’ll say, and now only have $8000 to buy something else. You have 10 years to retirement and if you averaged 10% per year with this $2000, this now becomes $4000, you pay $800 in extra tax on this extra profit, and are left with a net gain of $1600 by hanging on.
On your $10,000, this means an extra 16% return by not selling, all things being equal. If they were, this would be a serious consideration indeed. However, things are far from equal with investing and we may only end up with a 3% average return versus the normal 10% that we expect to get on average due to the reduced expectation.
We’re now left with a total of $13,000 pre-tax if we hold, pay the tax on this and end up with $10,400. If we sell and move from this paltry 3% return a year to 10% by having this money in better stocks, our $8000 grows to $16,000, we only have to pay tax on the extra $8000, and net $14,400 of profit after taxes, which is $4000 more.
It’s not hard to see from this that we can really help ourselves a lot more by avoiding underperforming stocks, and as a rule of thumb, if a stock isn’t cutting it, we need to get rid of it, even if we don’t have much time left to invest. If this is the case, this is especially a good time to get out because we want to trim risk at this point, and the tax differences won’t amount to very much to help offset these losses or lost opportunities.
If we have lots of time, culling the poorer stocks will provide the advantage of the greater returns that better stocks will provide, an advantage which is significantly greater than the tax advantages of holding these dogs.
These decisions are actually pretty easy to make, but a lot of decisions about how to best manage our portfolios aren’t so simple. All of our stocks may be good but they may all be in decline due to a bear market, and this can leave us in a difficult situation as we’re taking on both losses and risk and may be reticent to sell them. Perhaps there is a way that we don’t have to worry about this and can stay in our positions, keep all the tax advantages, never worry about selling, manage our risk as well as we need to, and even make a profit for ourselves during bear markets instead of losing.
Something like this would probably seem far too good to be true to the vast majority of investors, and you certainly will never get there by using any of the standard ways to hedge, like using bonds or gold or even more off the beaten track ones like options or inverse ETFs to do it. We could time our stocks to be in during bull markets and be out during bear markets, but the idea here is to stay in our good stocks until the end or at least until they turn to crap one day, to keep us from having to declare capital gains on them before we are ready.
There is a way to do this though, although it’s a plan that investors do not use at all and probably have never thought about using. The great majority of investors would probably shake in their boots when we tell them that they will be trading futures to hedge, and all the more so when we tell them that the goal here isn’t just to hedge against bears, where we’re looking to offset our losses with our stocks, the plan here really is to make money when this happens.
While we could even use this to hedge against garbage stocks, for this to work to our full advantage, we really need to have our stocks do well in bull markets, because we’ll be leaving things alone during these times.
Our Plan Will Look to Have Us Both Protected and Profiting from Bear Markets
We won’t be hedging at all when stocks are headed up generally, it is only when the market is pulling back that this plan will spring into action. It is not that we could not come up with a very good plan to leverage bull markets with this, but we’ll leave this one to the traders as we really don’t want to expose ourselves to more risk during the good times, as doubling our position on the long side with futures would involve. This takes real skill to manage and our plan cannot require all that much because investors just don’t have this.
We need to separate what we could call business risk with market risk, where business risk involves stocks going down when the underlying businesses aren’t doing so well, while market risk involves stocks in general moving down, and this is independent of how companies are doing, where even the best stocks can get hammered.
This does not replace the need to manage our stocks if we do choose our own, as we still need to cull when needed, tax consequences or not, because once again that’s not enough to want to hold junk longer-term. Market risk can’t be guarded against this way by just holding good stocks though because both the good and the bad get hurt by this, and this is going to require us to go flat when the weather is bad, where we either have to choose to be too exposed to risk or toss our idea of delaying capital gains taxation.
We could also just go with investing in an index, and this plan works great with that as well, but if you are up for picking your own, this provides for better opportunities and more control as the indexes don’t toss losing stocks like we can. The strategy with our futures positions will be the same regardless though.
Trading futures is an alien concept to just about all investors, save for those who might dabble in this on the side, and certainly don’t use this for the purpose that we will be using this for. The people that they get their investment advice from, whether that be advisors or people writing about these things, won’t be pointing them in this direction at all, and would probably even be alarmed if you told them you want to do such a thing.
However, we do tend to fear things that we don’t understand, especially if the idea is pretty novel, and this one surely is that. Futures are used to hedge a lot of things, but only the truly advanced would even think of doing this with stocks, and if they do, they are just looking to play defense, but we’re looking to go on the offensive with this instead.
The real key to this is that our futures positions are covered, similar to writing covered options where you sell options but own the underlying stock. Writing uncovered options is a practice that is best left to the real pros, and is far away from anything an investor should ever consider. Many do dabble in writing covered options though, but that’s too tame for us.
Covered options writing has the same inverse risk-reward profile as uncovered options writing, and just because the risk we take on is expressed in missed profits when the calls we sell blow up, if we have to give up a lot of profit from our stocks that we would have otherwise made, that’s still a loss that is measured in money.
With what we could call covered futures though, while we also expose our profits to risk, we aren’t shooting for the paltry premiums that covered call writing seeks, we’re shooting for the big bucks. The goal here isn’t just to cover losses to the downside with our stock positions, it is to make money on both the upside and the downside, like people who stop and reverse and make money on both the long and short side, while still staying in our stocks and maintaining a tax advantage.
It’s More Fun to Look to Make Money from Downturns Than to Lose During Them
You could set this up as a pure hedge and just look to break even during downturns, but downturns can be plenty profitable as well and we don’t want to just toss this opportunity just because we don’t like to short. We need to lose this idea to play this game, and this starts by realizing that the risk of a rebound during a significant market downturn really isn’t that high and nowhere near as high as the risk of a downturn during a bull market.
This is one of the big reasons why we don’t want to use these futures on the long side, even though we could ramp up our profits on the long side quite a bit with this. Stocks can fall pretty hard pretty fast, and this can deplete the reserve we’re going to need to set aside from this, while stocks don’t blow up to the upside anywhere near as much in a bear market.
The recovery after a correction or bear market is much tamer, where we don’t have to really worry about some event shooting things up, like they can crash down. This is even more important than it appears and is one of the keys that allows investors to get in on this game.
What we want to do here is simulate a complete reversal of positions during downturns, where if the market goes down 20%, not only do we not lose 20%, we make 20% instead. This is all synthetic though, because we won’t be touching our stocks at all, we’re just going to double the exposure on the downside to make it like we’re short with our entire stock portfolio.
You can’t even do this effectively with the stocks themselves, as some stocks are not so easy to borrow and you also pay a significant premium in costs when doing this, especially if things are actually bad. Brokers hold these and traders basically bid on them, and the more interest there is, the more they can charge for lending these stocks.
We obviously aren’t going to want to hold twice the value of our stock portfolios in reserve to do this, as buying an inverse ETF to offside our long positions would require, but futures trading allows us a lot more leverage than the small 2:1 you get with ETFs. The real beauty of this plan is that we only need to set aside a fraction of the value of our long positions to cover them off and even to simulate being fully short with them.
You don’t actually own anything when you trade futures, including index futures, as all that is being traded is the right to buy the actual contract at some point in the future. If you use this just to break even, that’s exactly what you end up with this, where the value of your futures contract goes down while you get a corresponding gain in value from your stocks.
If you trade the S&P 500 long and trade futures on it as well, this will come out even less commissions, although if you build your own portfolio that beats the market normally, the extra gain will be your profit. Doubling up turns this into a pure short play though, but if we confine this to periods where things will likely continue to drop, we can take advantage of these drops just like the short sellers do.
For this to work properly, we do need to confine ourselves to periods where the odds are truly in favor of going down and not just jump on any little pullback. This is where the money is made on the short side, and if you can imagine yourself back in 2008 with just about everyone scared to death as we start to slide off the table, that can be turned into a truly beautiful thing.
We don’t need anything quite this dramatic to make this work, and this would have worked very well during the dip in the last quarter of 2018, once the sellers took over. It wasn’t hard to figure out where to get off this boat, when the selling stopped and we started to inch up. Even if you held on a little into 2019, 5% into the recovery, which would have been an obvious mistake, you’d still come up with a tidy haul, where others have lost 15% but you made that much instead.
Not losing this 15% is fun, but it’s a whole lot more fun to make that much in just 3 months. Our stocks have lost this 15%, but since we made 30% from our futures position, we get to smile while others have pain on their faces.
We will need some extra over and above what we have invested in our stocks, or our main position if we are trading indexes, but we don’t want to hold this in cash since it isn’t earning anything for us that way. We don’t want to just put this in bonds either, we want this money to work as hard for us as the main portion but be at the ready when needed.
We also want to target our hedging properly, which means hedging when there is a need, not all the time like people like to do. This is a terrible idea that limits the potential returns of investors far more than they realize, and we don’t want to make less while being protected, it’s better to be protected even more and make more money to boot.
The way to accomplish this is to have enough set aside to do our work for us in the futures market, and have this long in a stock index while at the ready. We get all of the benefits when things are running well, and can re-deploy it on demand.
This is far from the crazy idea that it can initially appear to be. If you really want to be holding your stocks or the money you have in a stock ETF, for tax purposes, this does not mean that you are forced to suffer when the stock market runs bad, where mitigating your losses is your best hope. It’s better to hope for a lot more than that and especially to be able to smile regardless of whether the bulls or bears are running the show right now, which in itself is worth no small amount.