Tax Risk Into the End of the Year Gives Option Traders a Unique Opportunity

Editors second note on 12/4: We’ve received a number of comments and questions on the Special Dividend situation (thank you Steve Place!). We’ll post an explanation of what happens to options involved in a Special dividend tomorrow morning. Thanks for your comments.

 ***Editors note: We would like to welcome Steven Place to the CBOE Community. Steve Place is the founder and head trader at InvestingWithOptions. He specializes in derivatives trading, focused on equity options. His background in signals and electrical engineering gives him unique insight into how options are priced and how to exploit both price and volatility movement. When he isn’t trading and teaching others to become great option traders, he enjoys powerlifting and walking his pet corgi.

Welcome Steve (and your corgi)!

Turn on any channel with a 24 hour news cycle and it’s all about the upcoming fiscal cliff and whether the US political environment is too hostile for any proper deal.

But if we tune out the noise, there is a unique opportunity for option traders into the end of the year.

Regardless of the outcome in 2013, a tax hike on the investor class seems nearly inevitable. A major risk of the fiscal cliff is that dividend income will be taxed at the top marginal tax rate of over 35% instead of 15%.

And even if a deal is completed, there will most likely be some sort of hike in the dividend tax rate.

With that near term outlook, companies with hoards of cash are looking to distribute some of that to their investors by way of special dividends.

Holiday Bonuses Come Early for Investors

The interest in special dividends is the highest seen in many years– below is a Google Trends chart for the term “special dividends,” which is the largest interest since the MSFT special dividend news in 2004.

Many large companies have already announced plans to move some of their cash to investors. Las Vegas Sands (LVS) will be sending out $2.75 per share to their investors on December 18th. COST is putting out a $7 per share dividend. Ruger (RGR) is shelling out $4.50 per share.

As the end of the calendar year approaches, other companies may feel pressure from investors to distribute cash to avoid the tax burden into next year. And for traders looking to capture that dividend, extra gains can be made alongside short term capital appreciation.

How To Trade the Special Dividends

A basic dividend capture model would be to own the stock in order to receive the dividend distributions and then either hold onto the position as an investment or close it out after the dividend has been received.

The risk is that the long stock can expose the investor to market fluctuations that eclipse any gains made from the dividend, but an option trade known as a collar can be used to reduce the volatility.

A stock collar is the combination of long 100 shares of stock, short 1 call, and long 1 put.

This is a limited risk, limited reward play and is a slightly long delta position.

A collar provides significantly less volatility while holding a stock and waiting for the special dividend to approach.

An example of this is Las Vegas Sands (LVS, $46.65). There is a $2.75 per share special dividend payable December 18th to shareholders of record December 10th. December expiration is Friday, December 21st:

buy 100 shares LVS

– sell 1 Dec 48 call

– buy 1 Dec 44 put

2143
The potential profit is limited above $48, potential loss is limited below $44. (editors note: Memo # 30412 at theocc.com explains how strike prices may be adjusted for special dividends).