Susan,
This should answer your question
Harry
Trading Methods -- Shorting the Box
by Tom Gentile
Important Note: For Information Purposes Only. Consult your CPA or Tax Attorney for individual tax advice.
How can you protect a long stock position to prevent drawdowns? One particular way that I avoid drawdowns on long-term securities is with a method known as "Shorting the Box." This method of trading will allow a trader to hedge long term securities without selling the actual stock. It also does not involve buying or selling any options, therefore, eliminating the possibility of time value. Shorting the box involves selling securities against the ones you already own. For example, if you own 100 shares of IBM and you wanted to short the box, you would instruct your broker to sell short 100 shares of IBM. The broker would loan you the stock from the firms inventory, or sell short the stock on the exchange for you, while you continued to hold your IBM stock. Most people who want protection on their securities will buy puts as disaster insurance in case of a possible collapse of the securities that they currently hold. When shorting the box, the short stock will lose one dollar for every dollar made from the long stock held, and vice versa. As you can see, when you short the box, you have locked your gains, until you close out one side of the trade. What is the benefit of shorting the box? The biggest reason for shorting the box is to delay paying taxes against securities that you have made a tidy profit on. Let's assume you bought 100 shares of IBM at $50 per share, and the current price is $120. If you sell the IBM stock at $120 per share, you will have realized a $70 taxable profit. You may feel that next year your income may be lower allowing you to sell the stock and allowing you to fall into a smaller tax bracket. Yet if you wait, the market may correct itself, causing a decline in the price of IBM. By shorting the box, you have not closed a position, but now have 2 positions open. The profit is now locked but the trade will remain open until you close out one or more sides of the trade. You could leave the trade open as long as you like. Closing the trade out is done one of 2 ways. You can either leg out of the trade, legging out the short side first and then closing out the long side; or you can tell the broker to deliver the shares you own to cover the short.
The biggest misconception with shorting the box involves the long-term gain of stocks. Most people who first learn about shorting the box think to themselves, " I can short the box against that Netscape stock I bought 3 months ago at 20, and lock the profits in for a year, at which time I will close the position out and take the long- term capital gain tax against the trade." The IRS has taken this strategy into account and has set up rules regarding this which states the following:
"If you held property substantially identical to the property sold short 1 year or less on the date of the short sale, or if you acquire property substantially identical to the property sold short after the short sale, then:
1. Your gain, if any, when you close the short sale is a short-term capital gain; and
2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first."
IRS Publication 550
Notice here that this last quote taken from the IRS specifically states that you cannot short the box, and close the trade out to avoid the short-term capital gain on the stock. An example would be that if you held a long stock position for 50 weeks, you cannot short the box and close out the position 2 weeks later as a long- term capital gain. As a matter of fact, if you do short the box- - even with only 2 weeks remaining before the trade becomes a long-term stock- - the holding period is cancelled out and starts over the day you cover the short position of the trade. Traders beware that you cannot short the box to avoid short-term capital gains. |
