Grizzly BullsHow to avoid market corrections and drawdowns with limited tax consequences
Table of Contents
You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse. Seth Klarman
Introduction
Many investors are acutely aware of the pain of living through market corrections and crashes. The worst ones, like the Great Recession of 2007-2009 and Dot Com Crash of 2000-2003, take back years of gains and can take more than a decade to recover to the previous all time high. The S&P 500 (SPX) did not regain its March 2000 highs until the spring of 2013, and the Nasdaq (QQQ) had to wait all the way until summer 2015. Today in 2022, many individual stocks still remain below their 2000 peaks.
Most people do not have years or even a decade or more to sit idly by while their retirement accounts stagnate. If you are like most Americans, you need your money to continue growing while you work in order to secure a comfortable retirement, and you don't have that much time to lose.
Many people would like to sidestep corrections, drawdowns and market crashes, but they are worried that selling their stocks will result in a large capital gains tax bill that would negate most of the benefit of avoiding the downturns in the first place. Today we are going to discuss a few different strategies you can employ to legally minimize your tax liability when you are preparing for a downturn.
How can you predict when a correction is coming? Scroll down to the end of the article to find out
Strategies
Each of the strategies below takes advantage of how the capital gains tax code works in the United States and most other countries. You are only taxed on a security when you sell or when you receive a dividend from it. You can defer unrealized gains indefinitely. The fundamental reason why each of the strategies outlined below works is that you preserve your unrealized gains through any market correction. Instead of selling your holdings to avoid the downturn, you will keep them and continue to defer your long term gains while choosing to do one of the following...
Buy PUT options for protection
A put option is a contract giving the option buyer the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.
A put option increases in value as the price of the underlying security decreases. Due to this inverse correlation, when investors use put options as part of a risk management strategy, they are known as protective puts. Think of a protective put as a form of investment insurance or hedge to ensure that losses in the underlying asset do not exceed a certain amount.
Here's an example of using a protective put to prepare for a market correction:
| SPY | QQQ | VTI | |
|---|---|---|---|
| Portfolio positions | 300 | 200 | 100 |
| Current price | $475 | $395 | $242 |
| Expected correction bottom | $416 | $345 | $212 |
| Buy PUT quantity | 3 | 2 | 1 |
| Buy PUT strike price | $470 | $390 | $240 |
In this simple example, we assume that you hold a diversified basket of low-cost ETFs: 300 shares of SPY, 200 shares of QQQ and 100 shares of VTI. You expect a 10-15% market correction over the next few months. To prepare for it, you buy 3 SPY puts, 2 QQQ puts and 1 VTI put. This completely hedges your portfolio because each put option is a contract with the right to sell 100 shares of the underlying ETF.
You choose a strike price near the current price because you want maximum protection of your current portfolio value and are willing to pay a little extra premium to insure it. If you are less convinced of your correction thesis, you could save some premium by purchasing puts at a lower strike price at the cost of losing more money if your correction thesis comes to fruition. Choose an expiration date 1-2 months out from the current date.
If the correction materializes, your puts will increase in value roughly equal to the amount of unrealized losses you'll suffer on the ETFs, for a net $0 movement in your account. While everyone else just lost a substantial chunk of their account value, you preserved your capital! You can now sell your puts and buy the dip with the extra money you saved. You'll only owe taxes on the gains from your puts, and your long term unrealized gains on your ETFs remain tax deferred.
If the correction doesn't materialize, you get to claim a tax write-off for the losses on your puts (the premium paid). No market timing system can ever 100% accurately predict corrections, so this is bound to happen every once in a while. While you will be slightly worse off than buy and hold in this scenario, you should think of these small losses as long term insurance premiums paid to avoid the catastrophic losses that are bound to wreak havoc on buy and holders every decade or so.
Hedge with SPX Futures
SPX Futures are a type of derivative contract that provides a buyer with an investment tethered to the expectation of the S&P 500 Index's future value. Each contract has a value of 50x the current SPX price. For example, if SPX is currently trading at 4,800, then one contract of the SPX Futures is worth about $240,000. There's also an alternative micro SPX future contract that you can trade with the same effect that only has a multiple of 5x current SPX price (currently around $24,000).
Let's take a look at an example of hedging for a market correction with SPX futures:
| SPY | QQQ | VTI | |
|---|---|---|---|
| Portfolio positions | 300 | 200 | 100 |
| Current price | $475 | $395 | $242 |
| Expected correction bottom | $416 | $345 | $212 |
| Portfolio value | $142.5k | $79k | $24.2k |
In this simple example, we assume that you hold a diversified basket of low-cost ETFs: 300 shares of SPY, 200 shares of QQQ and 100 shares of VTI. You expect a 10-15% market correction over the next few months. Your total portfolio value is $245,700. This happens to be nearly the same as the value of one SPX Futures price (around $240,000). Therefore you can simply continue to hold all your current ETFs and sell one SPX Future contract. While QQQ and VTI don't move perfectly in-step with SPX, their betas have close enough correlation such that your account will still be appropriately hedged against the lion's share of damage any correction would take on an unprotected portfolio.
If the correction materializes, you would buy back the SPX future contract you sold when you believe the correction is over. How do you know when the correction is likely over? Try following one of our algorithmic trading models. You would only owe taxes on the gain from the SPX future; your long term ETF gains would remain unrealized so that they can keep compounding for you for decades. An extra benefit to this method is that the gain on your SPX future contracts are taxed by the special Section 1256 Contract rules. This means that no matter how long you held the future contract, you will always pay 60% long term taxes and 40% short term taxes on that gain.
If the correction doesn't materialize, you get to claim a tax loss instead. You can use this tax loss to reduce your other taxes on other capital gains or against up to $3,000 ordinary income per year. As mentioned above, you should consider these occasional small losses as insurance premiums that are well worth it in the long run to protect against the devastating losses bound to inevitably wreak havoc on the markets periodically.
Buy an inverse ETF
An inverse ETF is an ETF that is constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Buying and inverse ETF is similar to shorting a regular ETF, without having to worry about shares being available to borrow, owning a margin account or interest rates. The most practical inverse ETF for our purposes is SH which provides us with a daily return equal to -1x the SPX return for that day. For example, if SPX is down -1.5% on the day, SH will be up roughly +1.5% that day.
Here's an example of using inverse ETFs to hedge for a market correction:
| SPY | QQQ | SH | |
|---|---|---|---|
| Portfolio positions | 300 | 200 | 0 |
| Current price | $475 | $395 | $13.5 |
| Expected correction bottom | $416 | $345 | $15.2 |
| Buy quantity | 0 | 0 | 16,400 |
In this simple example, we assume that you hold a diversified basket of low-cost ETFs: 300 shares of SPY and 200 shares of QQQ. You expect a 10-15% market correction over the next few months. To prepare for it you buy 16,400 shares of SH. This completely protects your portfolio from any drawdown as you've effectively just made your portfolio market neutral.
If the correction materializes, you would sell the SH shares you purchased when you believe the correction is over. How do you know when the correction is likely over? Try following one of our algorithmic trading models. You would only owe taxes on the gain from SH; your long term ETF gains would remain unrealized so that they can keep compounding for you for decades.
If the correction doesn't materialize, you get to claim a tax loss instead. As mentioned above, you get to use this tax loss to reduce your other taxes on other capital gains or against up to $3,000 ordinary income per year. You should consider these occasional small losses as insurance premiums that are well worth it in the long run to protect against the devastating losses bound to inevitably wreak havoc on the markets periodically.
Conclusion
Today we've taken a look at how you can avoid market corrections without generating a large tax bill. Many investors are turned off from market timing before they've given it a real chance because they are irrationally worried about the tax consequences. There really is nothing to fear when you use one of the strategies outlined above.
But how do you know when a market correction or drawdown is likely to come? That's actually the more difficult part to figure out. That's why we started Grizzly Bulls. Let us do that hard work for you. Follow the signals generated by one or more of our models and you'll be well on your way to both avoiding drawdowns and outperforming the market as a whole.
