Hedging

http://www.minyanville.com/businessmarkets/articles/buy-and-hedge-what-is-hedging/11/16/2011/id/37958

How Hedging Can Afford Investors Tax-Planning Opportunities

But did you know that hedging affords the investor some interesting tax-planning opportunities? Hedging creates some interesting tax consequences. This article will walk you through the placement of long investments in one account and your investment hedges in another account. And by placement, I mean the ability to house your investment hedges in a taxable account while placing your underlying investments in a tax-advantaged account.

The best way to hedge is using options, and options have expiration dates. As a result, the hedged investor has to follow a routine to regularly update his hedges when the hedges reach expiration. The Buy and Hedge investor does this so that he maintains the proper hedged exposure. This routine creates buy and sell transactions on a periodic basis in your accounts. As you already know, these transactions all have potential tax consequences.

If you read the book, you know that your tax situation is important to manage. The only investment returns that matter are your after-tax returns. This creates some interesting tax management opportunities for the Buy and Hedge investor.

To be properly hedged, you must build downside protection in to your portfolio. In fact, the definition of "hedged" in the book is that you have limited the total loss your portfolio could incur in a worst-case scenario. One of the most popular hedging techniques I and co-author of the book Jay Pestrichelli teach is building a collar.

A collar is when you own a stock and then you purchase an Out-Of-The-Money (OTM) put as protection for the stock. And you also sell an OTM call on the stock to complete the collar. When using this technique, the protection is the OTM put. It protects your stock in the event of a decline below the strike price of the put.

As hedged investors, we look to...