Section 1256 Questions

Discussion in 'Risk Management' started by aquaswim47, May 1, 2010.

  1. I am curious if I buy an ETF option (like VTI or EFV), do I need to use Section 1256 tax reporting? What if I have a call or put spread? These instruments may provide lower interest rates even when factoring in the dividend payment that is lost if it is deep enough in the money in comparison with the margin rates available (based on the broker loan call rate). I've seen that there sometimes is very low interest rates on an annualized basis. This is particularly true for a deep in the money option that pays a very tiny dividend. At other times, the interest rates can be very high especially when deep in the money options don't exist or when the price change has largely been priced in.

    I'm curious because I would rather not invest in options if the tax complexity isn't worth the trouble since it's a very tiny (i.e. hundreds of dollars) amount invested in stock options.


    I have actually seen negative interest rates on put option contracts, rates below 1% annualized on calls, and rates as high as 14%. For instance, I once saw a $160 option that had a break even at $89 when the bond was at $95 with 6 months on it (6.74% for 6 months or 13.94% APY). If the dividend rate was 4.25%, your effective interest rate would be 9.69%. Of course, I didn't buy it. The price did fall to $87.30 and is currently at $92.17. The position is TLT. It could indeed fall like a rock when interest rates rise. Now with there being "stability" in interest rates, prices have dropped and it is much more reasonable to move in and buy it. For $5,220, you can buy the $140 put (break even of $8,780, costs 437), has a 7.56% interest rate with a 4.5% coupon rate so the effective rate is 3.06%.

    Currently, the interest rate on TLT on the $160 option on $72.10 is $87.9 break-even so the cost is $427 on $8,790 for 8 months is 4.86% so the effective interest rate is 7.37% less the dividend rate received so with a 4.5% interest rate, the interest rate is now 2.87%. You could also buy the $93 put for $2.53; it thus has a break-even of $90.47 (costs $170) and thus has an interest rate of 1.879% for 50 days so the interest rate is 14.5567% annualized. With a 4.5% dividend, you are talking about an approximate 10.1% if you own the put when the interest is paid.
  2. 1256 contracts that I know of do not apply to stock options or etf options. I trade commodities and used 1256 contracts but am pretty sure it would not work for you, there are many websites online that explain this.
  3. Thank you. That was very helpful.