Substantially Identical Securities - Bonds vs Options
Summary
A case will be made to correlate how the valuation criteria for bonds that lead to a finding of not substantially identical can correspond to option valuation criteria to show how different options can also be shown not to be substantially identical.
Review
Just a quick review as to why this matters.
According to Internal Revenue Code Sec 1091, the loss from the sale or disposition of stock or options is not deductible if, within a period beginning 30 days before or 30 days after the sale that generated the loss (a 61 day window), the investor acquires substantially identical shares or contracts or acquires a contract or option to buy substantially identical stock.
If one can prove that the “replacement” security is NOT substantially identical, then the wash sale rule does not apply. However, if the mark-to-market election has not been made then the $3000 capital loss limit still applies.
Bonds
As most readers of this website already know, a “bond” is generally evidence of an investor loaning money to an entity - corporate or governmental - for a fixed time at a fixed rate of interest.
Bonds are valued based on various components:
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Face value or denomination - a $1000 bond
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Coupon rate - 3%
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Term or maturity date - 10-40 years
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Number of payments per year - 2 or 4 per year
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Current market interest rate
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Issuer’s credit rating - AAA, AA, A, BBB
Bonds are considered securities, for tax purposes, and therefore can be subject to the wash sale rules.
The market value of a bond moves inversely with the fluctuation in interest rates. For example, a 10-year, 4% bond that pays pays interest twice per year may be valued at $927 but when interest rates are at 5% but will decrease in value to $857 when interest rates increase to 6%.
That makes sense because the coupon rate (4% in this case) stays fixed so the amount of interest received stays the same; therefore the price of the bond must change based on what the market demands. Essentially we are broadly considering the bond’s yield to maturity.
Now, there are also various components that determine the value of an option, and they are similar to the determinants of a bond’s value. Those option valuation components are:
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The price of the underlying
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Strike price
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Days to expiration
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Implied volatility
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Dividend yield of the underlying
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Interest rate
So, how can we use this information to counter the presumption that an option is substantially identical?
It’s always nice when you can use the Internal Revenue Service’s rulings against them. Let’s see how …
Bond & Option Valuation Component Comparison
The color-coding is an attempt to correlate the Bond Valuation components with the Option Value components.
Statutes & Case Law
The Regulations
Reg Sec 1.148-4(b)(2)(ii) states that “Generally, bonds are substantially identical if the stated interest rate, maturity, and payment dates are the same.” [Emphasis mine]
In the above component chart, stated interest rate would correspond to coupon rate, maturity would correspond to maturity date and payment dates would be a component of how the stated interest rate is implemented.
Therefore, the converse must also be true, that if those components are materially different or maybe even marginally different, the bond would not be substantially identical.
Rev Rul 76-346
A taxpayer sold US Treasury 6-3/8 bonds at a loss. The bonds were dated 2/15/1972 and matured on 2/15/1982.
The taxpayer, within 30 days, purchased US Treasury 4.25 bonds dated 8/15/1962 and mature on 8/15/1992.
These bonds, sold at a loss and replaced within 30 days, were determined not to be substantially identical and therefore the wash sale rule did not apply.
In making their ruling, IRS quoted Rev Rul 58-211 stating that “Generally, bonds are not “substantially identical” if they are substantially different in any material feature, or because of differences in several material features considered together.”
Hanlin v Commissioner, 108 F (2d) 429 (click to read the case)
Hanlin, although appealed to and decided in the Third Circuit in 1939, reveals many of the difficult issues surrounding any attempt to determine what is “substantially identical” when dealing with bonds, which are “substantially” (pun intended) less complicated than derivative instruments like the equity and index options trading in today’s market.
The taxpayer lost in Hanlin and his sale at a loss and repurchase of various municipal bonds was determined to be substantially identical exchanges and subject to the wash sale rules.
However, the judges in Hanlin, acknowledging that the word “substantially” was an “elastic weasel [of a] word”, provide current taxpayers with some ammunition to differentiate themselves from Hanlin.
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“Substantially identical” requires a differentiation in basic economic correspondence that is “so slight as to be unreflected in the acquisitive and proprietary habits of holders of stocks and securities”, meaning, the differences between the two securities won’t influence their purchase decision. In other words, an investor would be ambivalent between the loss security and the replacement security if comparing the two prior to any purchase.
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The judges dug into the “collateral security underlying the bond issues” and noted that, since some of the collateral consisted of first mortgages on farms in the Louisville KY vicinity and some were in the Wichita KS vicinity, that was enough disparity to consider the two securities not substantially identical, but other factors mitigated this finding.
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Again, in this case the taxpayer did not utilize this technique to diversify his municipal bond portfolio, but the Court concluded that “chronologically slight, but mathematically concrete, disparities in the maturity dates of the bonds sold and bought” … would lead to … “another method of insuring against undue losses.” “Objectively it is plain that maturity date has a direct arithmetical effect on the yield of a bond, since that all important percentage is a resultant of purchase price, face value, coupon rate (including length of interest periods) and duration.” [Emphasis mine]
Therefore, several conclusions may be drawn from Hanlin:
Based on conclusion 1 above, although subjective, if the investor has a decided bias, stemming from objective financial goals, for choosing one option over another, then when the economic climate changes, the choice of the subsequent option may not be substantially identical. For example, back in 2011, Research in Motion, the maker of the Blackberry smartphone, was a popularly traded stock. If an investor wanted to trade LEAPS on RIMM (now BBRY) there were several to choose from. If making the purchase decision during the second quarter of 2011 as to which LEAPS to buy, one might have been ambivalent as to term/expiry. However, the entire economic and financial climate changed during the third and subsequent quarters of 2011. What had been simply a decision between two LEAPS would now result in a loss on one, the subsequent purchase of the previously rejected LEAPS and a possible wash sale. It could be argued, under these circumstances, that the two options are now not substantially identical.
Chart from thinkorswim by TD Ameritrade
PowerShares ETF - QQQ
Based upon conclusion 2, the difference between the underlying collateral of two Land Banks, backed by the creditworthiness of the United States, would definitely translate into the underlying financial stability of two distinct companies, ie, Apple and Microsoft, not being substantially identical but more importantly the comparison between Apple and QQQ where Apple is the largest holding would also not be substantially identical.
Thus the sale of an AAPL option at a loss and the subsequent purchase of a QQQ option would not be substantially identical and therefore not subject to the wash sale rules.
Finally, based on point 3, the most important conclusion from Hanlin stems from the Court’s acknowledgement of the mathematical calculations inherent in the determination of bond value and its comparative impact on two bonds.
In Hanlin, the duration of the bonds exchanged, coupled with their similar yield characteristics, lead to a determination that the bonds were substantially identical. With regard to duration (term), the Court stated that “six months added to a duration of one year is vital added to a duration of twenty years, negligible.”
This is critical to option traders who trade in terms of months - with regular third Friday (Saturday) expirations - and even more important to those who trade weeklies. Couple these short terms with the increased volatility during earnings announcements, employment data releases and other unknowns … one could make the case that NO replacement option is substantially identical!!
Take a look at this example and decide for yourself. I am only showing the calls in this comparison for visibility purposes.
Compare the ATM calls for the AAPL 6 FEB 15 (FEB1 15) through 20 FEB 15 (FEB 15) expirations with the Call option chain the week after earnings. Do you believe they are “substantially identical”?
Note the amounts in the red circles which represent average implied volatility for the entire Call chain for that expiration.
AAPL Call Option Chain as of 1/23/2015 Prior to 4Q14 Earnings Release
Option chain from thinkorswim by TD Ameritrade
AAPL Call Option Chain as of 1/30/2015 After 4Q14 Earnings Release
Option chain from thinkorswim by TD Ameritrade
Observations
Obviously implied volatility makes the Earnings Week options higher priced. The FEB1 15 ATM calls reflect a 56% decrease in premium after the earnings announcement. (See chart at right)
Are the ATM options substantially identical one week later? Remember, we are only concerned with the options, not the underlying.
On 1/23/2015, the purchase of the FEB1 15 115 Call was a calculated risk. There was no Intrinsic Value in the option … essentially it was a wasting asset. On 1/27/2015 Apple announced blow-out earnings and guided higher so the stock price increased by 5.7% by the end of the day after the announcement.
Subsequent to that, Apple increased another 1.6% while the S&P dropped almost 35 points or 1.7%.
So, in that environment is the FEB1 15 115 Call substantially identical on 1/23/2015 to the same Call on 1/30/2015 with $2.16 of Intrinsic Value? (AAPL price of $117.16 less strike price of 115)
As the following chart shows, 52% of the option is now Intrinsic Value while only 48% is Extrinsic Value. In fact, Extrinsic Value has decreased 35%.
The following chart summarizes these observations:
Conclusion
If a Trader is a buyer of calls, the increase in Intrinsic Value is a favorable outcome.
For the seller of calls, that could mean that the Trader is out of the position (stock exercised in a covered call strategy), or a winner or loser in a spread strategy, either bull call or bear call, respectively.
However, the point is, are the options we have examined “substantially identical” one week after earnings? I believe you could make the argument that they are not, on a purely option level.
Why on an option level only? Because IRS could argue that with the FEB1 15 115 Call, regardless of its value gyrations during earnings, the Investor/Trader is trading Apple at 115 or would end up with Apple stock at 115 … and Apple stock IS substantially identical to Apple stock.
Bonds vs Options
So on an option level only, what makes two options not “substantially identical”? For that answer, we need to look back at the bond valuation issues and correlate them to option valuation techniques.
Remember that, pursuant to Reg 1.148-4(b)(2)(ii) bonds are generally substantially identical if the stated interest rate, maturity, and payment dates are the same.
Let’s take a look at our valuation component chart again. The non-grayed-out items pertain to the criteria mentioned in the Regulations as do the Scenario chart items highlighted in green below.
Scenario 1
On the chart to the right there are two valuation models, one for bonds and one for options (Black-Scholes). Each model uses certain criteria to determine an estimate of bond value or option price, respectively.
Scenario 2
On the chart to the left there are again two valuation models, but the inputs have been changed pursuant to the Reg Sec 1.148 and Hanlin criteria and correspondingly different values calculated.
Comparison of Results
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The key Reg 1.148 and Hanlin criteria were changed materially but the price of the bond did not
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The corresponding option valuation criteria changed materially but the option value did not
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According the authoritative literature, even though the key criteria in Scenario 1 and Scenario 2 changed materially, the price/value did not. The bonds would NOT be considered “substantially identical” so it should follow that the options would not as well.
Download a Template to Determine if an Option is Substantially Identical to Another
Is an option roll substantially identical to the original position?
In the Variance % column you decide if a difference in strike price, expiration date and a 28.1% variance in price to the original option is a 'Substantially Identical' option
Click image to download; No viruses are present.
Video Tutorial - Substantially Identical Options
Substantially Identical Options
A substantially identical option:
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Would have the same underlying, same strike and same expiration
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When is the determination date? Date of exchange/roll; Date of expiration? If it is another option with a longer expiration, the original option won't exist and the expiry of the replacement
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What about movement of the two options versus the underlying? ITM would behave differently than an OTM option as delta increases/decreases
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What about the fact that exercise or assignment would be into the same underlying? This is the position IRS would take but I believe that can be overcome by looking at two things:
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The option behavior versus the change in stock price, and
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The option variance when compared to each other as the stock price changes
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Another substantially identical option consideration will be if the two options are deep ITM, ie, their delta is 95% to 100%
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Remember that an option is a derivative instrument and it's value is derived from the underlying stock price and the amount of "in the money - ness" and whether the derivative instrument is American style or European style, exercise of rights prior to expiration or only on the expiration date, respectively. Cash-settled index options are typically not subject to early exercise.
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Below is a downloadable template to model two options as the price of the underlying changes
Summary
What this lengthy page attempted to develop was the fact that IRS has codified criteria for determining if bonds are “substantially identical”. By avoiding the characterization of substantially identical, the bond trader can also avoid the onerous wash sale provisions.
Using the Treasury Regulations, Revenue Rulings and case law it was demonstrated how bonds are determined not to be substantially identical.
A hypothesis was developed that correlated bond valuation criteria with option valuation components. It was then shown that by materially changing those criteria, that bond and/or option valuation might not change leaving the trader with a substitute of similar value/price that by definition is not “substantially identical”.
Whether this logic would hold up under IRS or Tax Court scrutiny would only be conjecture, but, it is usually fruitful to use established IRS rules against them.
Mark-to-Market
For the short-term Trader, this problem may be solved with a Mark-to-Market election.
By making the MTM election, a Trader avoids two major restrictions:
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The Wash Sale rule
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The $3000 capital loss limit
There are a number of benefits and several scenarios that can work to the Trader’s detriment, all of which are discussed on the Mark-to-Market page.
By viewing the accompanying video and using the MTM Template available on this website, making the election is not as difficult as one might think.