How to avoid market corrections and drawdowns with limited tax consequences — Grizzly Bulls Blog

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.

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.

Using PUT options for portfolio protection

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).

Selling SPX futures for protection

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.

Buying inverse ETF for protection

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.

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Lee Bailey

Lee Bailey

Founder @ Grizzly Bulls. We’re on a mission to democratize access to the most sophisticated trading strategies by publishing signals from our algotrading models