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Using index options for a profitable trading strategy

Using index options for a profitable strategy with cash accounts

As you all perhaps know, there is a huge tax advantage for trading index options versus options on regular equities in regular brokerage cash accounts. There are various types of financial products with different tax treatments, and Section 1256 contracts have the best overall tax advantages. Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, many tax preparers overlook essential differences in tax treatment for these groups, resulting in overpayments. Education is key.

It’s important to distinguish between securities vs. Section 1256 contracts with lower 60/40 capital gains rates vs. other types of financial products like forex or swaps with ordinary income or loss treatment. Plus, there are various elections available to change tax treatment. Options on broad-based indexes are also 1256 contracts.

60/40 capital gains rates

Section 1256 contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate.

At the maximum tax brackets for 2018 and 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies.

For example: Make $100,000 in 1256 contracts in the 35% ordinary bracket and save $12,000 (12%) with 60/40 rates.

We show you a working example of a trade we took today using the Nasdaq index and used options to trade. Historically, the Nasdaq (also commonly referred to as NDX) moves much more vigorously intraday with bigger swings in price versus the broad market or the S&P index (also commonly referred to as the SPX).

In today’s chart-based example, we use the bottom of the move from the liquidation break in the Nasdaq index on Friday when the Nasdaq-100 fell to a low of 10945. We measure this using standard Fibonacci technical analysis, targeting two key levels in the Fib sequence of measurements, the -61.8% and the +123.6% lines. We measured the initial move which occurred on Friday during the afternoon session from that 10945 low to the high the index made ar around 2:45 pm Eastern on Friday. The measurement tags the -61.8% line to the tick and runs up to the +123.6% profit target. A long extension on the gap-up on Monday into the intraday high made at 11363.25, would then entail measuring the previous as a continuation long-extension. Notice how this long extension behaves identically to the original measurement pulling back to the Fib -61.8% line again to the tick and targeting 11428 as the price target into the next few sessions.

We took an options trade which has a Sept 21, 2020 expiration and 11400 as the strike, acquiring the single call option with the NDX at or around 11170 (which forms the -61.8% retracement price) and getting an average fill price of $90 per option or $9,000 of capital outlay. We exit the trade the following day with the underlying index value at 11428 and the option price at $ 10,260.

Chart

Download here: Chart of NDX

Actual trade log (download here): Trade extract

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