My assumption is that you are overweight these assets relative to your desired allocation, which is why you you are selling puts on these particular assets in the first place?
Rebalancing, not so much overweighting. Right now we're at the lower end of our desired asset allocation for these shares. If the market keeps dropping then we'd need to buy more shares in Berkshire Hathaway and IJS to stay within their asset allocation band. Of course if the market goes racing up next week then we might end up overweighted in those assets and have to sell some shares... but it's probably too soon to start talking about market recoveries.
In the case of "you are overweight these assets relative to your desired allocation", you might be thinking of selling covered call options. If the price of the shares rose above the strike price of the covered call option then those shares would be called away and our asset allocation would be rebalanced.
When you sell at a loss relative to market value when the the option is called can you harvest a tax loss on that loss relative to the true value? I would assume not.
I sold put options, which means the owner of the options can make us buy the shares at the strike price. Ideally the put options would never be exercised and they'd expire.
If the markets dropped way below the strike price of the put option then we'd still pay the strike price for the shares. I'd feel pretty stupid for buying too soon, but we got paid a premium for selling the put so that makes up for some of the gap. We also got a good discount on shares that we'd be happy to own for at least a few years.
I'm not sure how the owner of the option would calculate their capital loss. It'd be the difference between what they paid for the shares and the strike price at which I bought them. But they might not have a loss-- when the other guy buys my put option, they may be simply trying to protect their gains.
The brokerage's 1099 statement (and tax software) would have a pretty firm opinion on how to calculate the capital gain/loss.
As a rebalancing mechanism, isn't there the risk that the equity that you are selling a put on will be underweight at the time you were forced to sell it, becoming counterproductive to the rebalancing exercise?
The reason for selling a put is to commit to buying shares if the share price drops below the put's strike price. By the time the share price drops enough for that to happen, the shares we already own will be below the asset allocation we want. The put will be exercised and we'll end up with more shares. We'll be back in our asset allocation band.
Isn't this a real example of big downside with extremely limited upside? arent you taking on the possibility of complete loss of capital if the company (like Berkshire Hathaway) goes bankrupt and you're forced to buy their shares and hold them in exchange for 7% APR?
Options can quickly magnify the downside (and the upside). One of the factors in the price of the option is the market volatility, so the bigger the volatility then the more valuable the option.
In the BRK case, we've agreed to buy at $125/share. If Buffett steps down before the expiration of the option, it's quite likely that a bunch of panicked "investors" will dump their BRK shares and drive the market price down below $100/share (below book value). At that point the owner of my put option would gleefully force me to pay them $125 for shares that are currently selling for less than $100. Right off the trade we'd have over a 20% loss.
From then on I'd hope that committed investors would start buying BRK shares and help drive the price back up. (One of the buyers would be Berkshire Hathaway itself, because they know a bargain when they see it.) If the owner of the put option sold to me at $125/share and thought BRK was still worth more than market price of <$100/share, then they'd probably use their cash (received from me) to buy more BRK shares right away at the bargain price of <$100/share.
I'd be holding BRK shares that I paid $125 for, and I'd be a little pouty-faced about the loss, but I knew that this low-probability event was one of the risks. I have enough assets and income to hold the shares until they recover their value, even if it takes five years or more. In fact I'd probably be having an intense discussion with my spouse about buying more of those BRK shares for less than $100... either by selling more put options or by simply buying the shares at the market price.
It's also possible that the value of BRK could go to zero, which would be a total loss from $125/share. I suspect there's a higher probability that I'd be struck by lightning during a shark attack. But that's what makes it very difficult to quantify the risk of the option.
By the way, there's a small group of people who think that Buffett & Munger's continued management of the business (and the unknown identity of the successor) is actually holding down the share price. If Buffett & Munger stepped down tomorrow, Berkshire's share price might actually shoot up.
I'm occasionally asked about rebalancing in retirement, so here's a full-disclosure post. This is a little fast and sloppy because I'm trying to get it up before the markets open on Wed 26 Aug.
If only the best posts of the rest of us could be as polished as this "fast and sloppy" one of yours!
Thanks. I still edited, but it was a long day.
My education started with McMillan's "Options As A Strategic Investment" textbook. Next I read through the CBOE's education center. Both of these resources are designed to stupify you with eye-glazing boredom, but I'm a nuclear submariner who used to read reactor plant manuals for fun & profit. My point is that if these two references don't fascinate you to your core, then you shouldn't trade options.
For my money, this is the most important bit of wisdom in the entire post. I'm a corporate lawyer with a borderline-unhealthy interest in investing, and, generally speaking, I wouldn't touch derivatives with a ten foot pole.
Yep. Another one of my motives (besides the experiential learning) is "immunization". If I learn from this in my 50s (and ideally get over it) then I won't be tempted to start going on margin with option chains in my 80s.
Statistically I'm at the peak of my cognition right now, and I expect to shut off my margin account in five years when I turn age 60.
Another good point.
The emphasis is on the word "statistically". I'd like to think I'm getting better. Some think I may have already peaked.
My spouse's Reserve pension kicks in when she turns age 60. At that point she's also agreed that it's her turn to take the next 30-40 years of financial management. Before I can turn the duty over to her, though, she wants it all cleaned up and simplified and in autopilot. I suspect that's because she's going to ignore the whole thing for another two or three decades and then dump it on our daughter.
This is a great post - hopefully will be repeated in a similar form on your blog also.
Thanks-- I'm ambivalent. I have plenty of hardcore military topics to write about (like Reserve retirement) and selling options is definitely an edge topic. I think this topic is also more compelling during the event: "what I'm doing now, let's see how it works". It won't be as interesting if I write it up in six months as "here's what I did last August and how brilliantly it worked out".
But if I'm presented with another "opportunity" in six months or so (when I've cleared my topic backlog) then maybe I'll write it up.
Or I could write a post about "If you must trade options, here's how to stay out of trouble". That might work well as a guest post on someone else's investing site.
I bet Google AdSense pays a lot of money for options-related keywords!