Options trader hedge fund pdf

Options trader hedge fund pdf First, let me say this: Most people lose money trading options. It’s a very difficult game. But if you can find an edge, the returns can be huge. One of the best option-trading hedge funds in the business, Cornwall Capital, has averaged 51% annualized over the past 10 years. That turns a mere $20,000 investment into $1.2 million, in less than 10 years. Two of the best option strategists that have ever worked on Wall Street are Keith Miller, formerly of Citigroup, and John Marshall, of Goldman Sachs. Both Miller and Marshall happen to be Blue Jays (i. e., Johns Hopkins University grads), like me. If you can ever find any of their research studies, print them out and examine them closely. They are excellent — and will give you an edge. Below are the rules the best hedge funds use when trading options: Options are like a coin toss you’ll be lucky if half your option trades are profitable. That is why you have to make sure you get paid for the risk you take. Only trade an option if your projected return is a triple or better. To do this you will have to buy an out-of-the-money option. And you should go out at least two months, preferably longer. Now, here’s the math: Let’s say you make 40 option trades a year.

Odds are at best you will only make money on 50% or half of these trades. Therefore, if you had 40 options trades and 20 of those trades expired as worthless, and the other 20 option trades averaged a triple or more, you would still make 50% a year. For example, on a $40,000 account taking 40 trades a year, if 20 option trades lose everything and the other 20 trades give you an average return of 200%, your account would be worth $60,000, giving you a 50% return. So $20,000 would go to zero on the option trades that expired worthless. The other $20,000 would go to $60,000 on a 200% return. Price predicts a stock’s earnings and fundamentals 90% of the time. According to Keith Miller of Citigroup, a stock will start to move one to two months ahead of its earnings date, in the direction of the earnings report. This means if a stock starts trending higher or breaks out higher before the company reports earnings, the earnings report will be positive 90% of the time. When you are buying options on a stock, make sure the stock is owned by an influential investor or activist. These investors, such Carl Icahn, Barry Rosenstein of Jana Partners and the rest, are always working behind the scenes to push the companies to unlock value this can come in the form of incremental positive change or big one-time catalysts. This positive announcement or catalyst usually emerges after the stock has moved up in price. So when you see an activist-owned stock breaking out, or trending higher, there is usually a good chance change is coming.

Thus, you’ll want to buy calls on this stock immediately. Only trade an option if there is an event or catalyst that will reprice the stock. This could be an earnings announcement, a company’s Investor Day or an annual meeting. Only buy options when both implied volatility and historical volatility are cheap. Be a value buyer of options. Watch volatility. Buy volatility only when it’s cheap. A perfect example of an option trade that fits all of the above criteria is Walgreens ($WAG). > Jana Partners, run by billionaire Barry Rosenstein — one of the top 5 activist hedge funds on the planet — owns more than $1 billion of Walgreen’s stock. That’s more than 10% of the fund’s overall assets invested in Walgreen’s (Jana has $10 billion under management). Even better, they just added to their position last week, buying $77 million more during the market correction. > Walgreen (WAG) just broke out of a consolidation pattern, and it looks like it is ready to make a big run (see chart below).

> Walgreen reports earnings on December 22nd. So whichever way the stock moves over the next month or two will predict whether the company’s earnings are positive or negative. Based on the stock’s current price momentum, the report will be positive. > The Walgreen $65 calls are cheap, especially since they expire only two days before the company reports earnings. You can buy the Walgreen December $65 calls for just $1.10. That means, at $66.10 or higher, you will make money on this option. My price target for Walgreen, based on its recent breakout, is $69. That also happens to be where Walgreen gapped previously. > If Walgreen stock trades just 10% higher to $69 by December 20th, you will more than triple your money on this option in less than two months. This is the risk-reward profile you want when trading options. Your goal should be to make 50% a year. The new Firefox. Download Firefox — English (US) Your system may not meet the requirements for Firefox, but you can try one of these versions: Download Firefox — English (US) Your system doesn't meet the requirements to run Firefox. Your system doesn't meet the requirements to run Firefox. Please follow these instructions to install Firefox.

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He continually refined his strategies. After graduation, he went to work for KPAC Solutions, a private-investment company focused on acquiring and turning around distressed manufacturers. This enabled Patton to learn about commodities, since many of these companies were involved with commodities in some way. Patton, now 25, has since founded Steel Vine Investments. Fund Manager Looks To Pocket Premiums From Options Positions. Patton aims to sell options far enough out of the money that strike prices are never triggered, allowing him to keep premiums collected for selling the option. This puts a ceiling on the profit from any one position, yet also takes away the pressure of having to correctly predict whether a market's next move will be up or down. An option is a contract giving the buyer the right, but not the obligation, to buy or sell a commodity or stock at a fixed price, on or before a certain future date, from the seller. He generally sells options on stocks and commodities that are 30% to 100% out of the money, with expiration anywhere from three months to a year away. He looks for strike prices that he views as "historically or statistically unlikely" within the options' time frame, in many cases selling options at strikes for which prices have never achieved. "You're looking to capture the premium of selling those options," he said. "The historical issue with selling options is that there is a limited profit potential. The most you can make is make is the premium you are paid to sell that option. You can't make a single dollar more on that position, whereas your loss is theoretically unlimited.

Silver could go to infinity, and you would have unlimited losses. "But, the trade-off is that the likelihood you are going to keep that premium is very high…There are a lot of great statistics out there saying that roughly 80% to 85% of all options expire worthless." As of this interview, silver was just under $50 an ounce. A trader selling a $75 silver option expiring on Nov. 22 would receive a premium of $4,100, which he would keep as long as any rally stops shy of $75, Patton said in listing a hypothetical trade. The risk would be that silver does in fact hit that price. If silver keeps rocketing higher and threatens this price, Patton would favor simply closing out a position. By July, that option might be worth say $7,000, he said. A trader would have to pay this to close out, leaving a loss of $2,900, which would be less than if the options were actually triggered. A "more aggressive" way to manage risk, which Patton said he tends to avoid, would be to hedge with a position in the futures market.

For instance, if a trader sold a silver call at $75, he might buy a silver futures contract. Then if the option call ends up a loser, this would be offset by a gain in the silver futures contract. A double benefit would be if silver rises but stops shy of $75 by expiration. Then a trader would both keep the premium for selling the option and also gain on the rise in the futures contract, Patton said. However, should the futures contract instead decline, the futures loss might end up offsetting the premium from the option. "You are paid a certain premium, and if you lose all of that money trading silver (futures) trying to hedge yourself, then you've done yourself no good," he said. "I just think the smarter way to go (to manage risk) is to just close out the position. Have a set, defined stop loss. Say 'if it reaches this point, I'm going to have the discipline to close the position.'" With Patton's trading system, he simply has to decide "where commodities will not go" rather than "where commodities will go." By contrast, a traditional futures trader has to decide whether the market will rise or fall from the current price. "If you say it's headed higher and it goes lower by one penny, you've lost money," Patton said. He generally trades only equities or commodities with strong volume. He sticks to stocks in the Dow Jones Industrial Average or S&P 500, which seldom lose more than a percentage point or two a day. He avoids small, developing companies, such as a small biotech firm that could be vulnerable to 20% moves in a single day if major news breaks.

Assets under management in his fund are just under $5 million, which Patton concedes are "small potatoes" in the world of hedge funds. However, he has not been actively seeking capital as he developed his strategies. Starting May 1, however, the fund will be opened up to institutional investors. Steel Vine posted returns of 27% in 2009 and 26% for 2010, he reported. Patton avoids putting more than 10% of a portfolio in any single position. He favors diversification, yet said "don't diversify just for the sake of diversifying," instead only putting on positions when confident in them. His main advice for novices is to work with a mentor, such as a broker or another trader who can help walk them through potential pitfalls. "There's a lot to be said for personal experience, and paper trading will not do it for you," he said. "Paper trading is so different…because you don't have the gain or loss of capital and swings of emotion that come with that. I'm not nearly a big of a believer in paper trading as most." The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

Option Trader's Hedge Fund, The: A Business Framework for Trading Equity and Index Options. This product currently is not for sale. Your Price: $39.99 List Price: $49.99 Includes EPUB, MOBI, and PDF About eBook Formats. This eBook includes the following formats, accessible from your Account page after purchase: EPUB The open industry format known for its reflowable content and usability on supported mobile devices. MOBI The eBook format compatible with the Amazon Kindle and Amazon Kindle applications. PDF The popular standard, used most often with the free Adobe® Reader® software. This eBook requires no passwords or activation to read. We customize your eBook by discreetly watermarking it with your name, making it uniquely yours. Features. Learn how to make consistent profits from selling options by managing your option portfolio like a dependable business enterprise. For those with some knowledge of trading options who want to become consistent income earners. Gain pearls of wisdom from both a professional options trader and coach, and from a hedge fund manager focused on managing an options based portfolio as a steady, dependable business. Offers a complete "operations manual" for setting up your own "one man" business. Copyright 2012 Dimensions: 6" x 9" Pages: 240 Edition: 1st Book ISBN-10: 0-13-282340-3 ISBN-13: 978-0-13-282340-1. In this book, a hedge fund manager and an option trading coach show you how to earn steady, reliable income selling options by managing your option trades and running your option portfolio as a real business with consistent, steady returns.

Packed with real-world examples, the authors show you how to manage your own &ldquoone man&rdquo hedge fund and make consistent profits from selling options by applying the basic framework and fundamental business model and principles of an &ldquoinsurance company&rdquo. This framework helps you to apply your option trading method to a solid, predictable, business model with consistent returns. For someone who has some knowledge of trading options and wants to become a consistent income earner. The authors provide a complete &ldquooperations manual&rdquo for setting up your business. Gain pearls of wisdom from both a professional options trader and coach, and from a hedge fund manager focused on managing an options based portfolio. Online Sample Chapters. Download the sample pages (includes Introduction, Chapter 1 and Index) Part I: The Framework. Chapter 1: The Insurance Business 5. Chapter 2: Trade Selection 19. Chapter 3: Risk Management 31. Chapter 4: Trade Execution 43. Chapter 5: The Trading Plan 55. Chapter 6: Trading Infrastructure 63. Chapter 7: Learning Processes 73. Part II: Implementing the Business. Chapter 8: Understanding Volatility 81. Chapter 9: Most Used Strategies 89. Chapter 10: Operating the Business: Putting Together TOMIC 1.0 from A to Z 121. Part III: Lessons from the Trading Floor. Chapter 11: Lessons from the Trading Floor on Volatility 131. Chapter 12: Lessons from the Trading Floor on Risk Management 145.

Chapter 13: Lessons from the Trading Floor on Trading and Execution 155. Chapter 14: Lessons from the Trading Floor on the Other Greeks 173. Chapter 15: The Beginning 191. Appendix A: Recommended Reading 195. Appendix B: method Learning Sequence 199. Appendix C: OptionPit. com 201. Appendix D: Kite Spread 203. Submit Errata. Get unlimited 30-day access to over 30,000 books about UX design, leadership, project management, teams, agile development, analytics, core programming, and so much more.

How Hedge Fund Managers Use Equity Options. 07152013 6:00 am EST. One of the attractions of volatility trading is that the hedge fund manager can profit on a given index whether it goes up or down by using options, writes Stuart Fieldhouse of the Options Industry Council . Volatility as an Asset Class. Volatility trading possesses a number of attractive qualities for both the fund manager and his ultimate investor. As an asset class, the cost of volatility increases when uncertainty increases, but also has a tendency to revert to a mean. It can be traded in a number of ways, including purely speculatively, or arbitraged (e. g., index vs. stock, or short-term vs. long-term, or implied vs. historical). But at the core of a successful volatility-based method lies the effective use of options. As a hedge fund method, volatility trading has evolved significantly since the financial crisis, when many volatility specialist funds posted headline numbers. Since then investors have begun to see the volatility fund as more than just a hedge against volatile markets, but also as an investment in its own right. This has occurred as skilled fund managers have begun to demonstrate that they can go both long and short volatility.

The VIX index&mdashthe CBOE (Chicago Board Options Exchange) volatility index (VIX) (VXX)&mdashhas established itself as one of the key volatility benchmarks in the market and offers some excellent options trading opportunities, allowing the fund manager to go long or short vega (the option's level of sensitivity to changes in the volatility of an underlying asset). While the VIX contract is the volatility option flagship, other volatility indexes are gaining in popularity, including the CBOE Emerging Market ETF Volatility Index (VXEEM) and CBOE Gold Volatility Index (GVZ). Implied volatility is part and parcel of the way options are priced. The fair price of an option will reflect not only the implied volatility, but also the market dynamics and the forces of supply and demand. This leaves it open to arbitrage strategies where the fund manager will compare the forecast volatility in the underlying instrument (e. g., an index) with the existing implied volatility of an option. With the accurate pricing of options under the Black-Scholes formula, this will require a degree of reliance on the manager's forecast for volatility, and analysis that can reveal mispricing situations that a shrewd manager can capitalize on. Funds can also hedge implicit volatility exposure&mdashrisk arbitrageurs, for example, might be hoping to take advantage of narrower spreads in the stocks of companies planning to merge. Using Options to Trade Volatility. Funds which specialize in volatility trading will often take advantage of unusually high implied volatility by selling both a slightly out-of-the-money call option and an out-of-the-money put option coupled with the purchase of both a call further out on the upside, and a put further out on the downside. This trade, commonly referred to as an iron condor, is one of the favored means of making money on implied volatility. NEXT PAGE: Institutional Volatility method Usage. In the past, options contracts tended to be over-priced, partly because 99% of the market participants used to take a directional bias. Prior to today's technological trading enhancements, this created plentiful arbitrage opportunities as hedge funds took advantage of this available alpha. Some early volatility funds were simply long equity volatility trackers, a similar function to what a volatility index tracker might provide today. Institutional Volatility method Usage.

Click to Enlarge. Because listed options markets are highly liquid in broad market indices and US blue chips, volatility strategies can grow into multi-billion dollar portfolios. Successful funds in this area are those which can continue to evolve and capitalize on the changing nature of both underlying markets and the available opportunities in options markets. Most hedge funds trading volatility remain focused on the equity or index volatility space, but volatility hedge funds are also able to effectively trade volatility over a number of different markets, including commodities and currencies. This expands their opportunity set and also cuts down on concentration risk. Volatility trading can be both a fundamental and a quantitative method, although the more successful funds are increasingly adopting more of a rules-based approach to the asset class. One of the attractions of volatility trading, say on an index, is that the hedge fund manager can profit on a given index whether it goes up or down through the use of options. Delta hedging allows the fund manager to hedge away the linear component of a call option to produce a security with a curved P&L. For the trader with a long position, this can make money if the realized volatility exceeds the implied volatility with sufficient magnitude. A delta-hedged option does not represent a pure, clean bet on volatility, as it tends to assume smooth stock movements, zero transaction costs, and relies upon known historical volatility.

In reality, markets do not conform to a purist application of options pricing, particularly as the manager cannot hedge continuously and must also hedge discretely. Imperfections of this nature can undermine the gains, which the fund could make in theory. Hedging continuously, for example, will introduce additional transaction costs, which will impact the manager's expected return. Black-Scholes requires that an index must have some expected level of future volatility to make an options price a fair one, but if the model were to be right, then all options would need to have the same implied volatility, which simply isn't the case. This makes hedging harder when trading volatility. Since 1987, volatility skews have been observed as persistent, linear and inconsistent with Black - Scholes. The so-called 'volatility smile' (variation in implied volatility with strike and expiration price of options) has been observable across a range of markets, including currencies. NEXT PAGE: Favored Volatility-Based Strategies. Favored Volatility-Based Strategies. The Straddle : A long straddle is achieved when buying both a call option and a put at the same strike price and expiration date. Because the positions are at-the-money, they provide the best time value and the greatest absolute volatility exposure. This is a short-term trade with the expectation of an immediate increase in volatility. They effectively double the exposure to volatility when compared with a single option purchase, but have significant time decay. (See Fig.2). Click to Enlarge.

The Strangle : Less costly than the straddle, the strangle trade uses the same maturity for the two contracts, but different strike prices. The same off-set benefits are achieved, generally using out of the money options. This means a smaller premium compared to the straddle, with less time decay. Out-of-the-money options also experience the most impact in terms of percentage changes if there are sudden, drastic changes in implied volatility. The two trades above are best used when the fund manager does not have an opinion on where the underlying market is going, but feels that volatility will increase over the short term, and certainly before time decay takes out the value of the position. Selling Volatility : If options are being over-valued, an astute manager can sell volatility. Much depends on whether he can establish an accurate estimate of future volatility and use those options strategies, which will benefit from a fall in implied volatility. A short straddle trade is considered one of the purest approaches to this opportunity although a short strangle (sale of an out-of-the-money call and an out-of-the-money put) may also work. Selling volatility allows the fund manager to make money on both a decrease in volatility and time decay. Long Call Butterfly Spread : This involves the sale of at-the-money options with the highest time value while buying both out-of and in-the-money options as disaster insurance. The low time value options are used to limit the loss risk on both the upside and downside of the trade. A net premium must be paid to establish the position.

There are a number of different approaches to establishing a butterfly (e. g., a bull call spread coupled with a bear call spread). It is a short volatility trade, making money from decreasing volatility. It is often used by under-capitalized traders who wish to sell volatility but also protect against the potential unlimited loss in the straddle or strangle approach. Calendar Spread : One option is sold and another bought at the same time, with the only variation being the month of expiry. The goal is to have the underlying price stay close to the short strike price heading into the expiry of the contracts. The premium of the sold, or nearer-term, option should decay faster than the bought, or further-out option. The bought option has a higher sensitivity to implied volatility, allowing the manager to make money if the implied volatility of the options rises. Calendar trades can be speculative (strike price of the spread is further away from current price, requiring a larger movement in favor before profits are realized) or income-based (decay of the option premium will go in the manager's favor). (See Fig.3). Click to Enlarge. Markets are frequently unpredictable. Managers trading volatility as an asset class must be aware that they own both term volatility and specific strike-based volatility. In addition, the models they use will vary depending upon the underlying market.

Currencies, for example, will tend to have stochastic volatilities, while interest rate volatilities will revolve around rate levels. It can also be extremely hard to test strategies effectively. When trading options to capitalize on volatility, managers must also be sensitive to time decay. This can make it expensive to keep a given position active, and has proved costly in some instances where volatility has remained persistently low, sometimes unexpectedly so. Discipline is required when using a spread-based method to capture volatility. The trade must be taken off as a spread rather than viewed as separate components . If volatility has been bought at a low level with the expectation that it will be higher in a few days, then the manager must be resistant to underlying market jolts and the temptation to close one side of the spread. Sellers of volatility must also be aware that, as with a conventional short trade, there is significant loss potential. This is a particular risk for a fund that becomes a habitual seller of volatility. Pre-2007 volatility specialists were heavy users of OTC options, but since the financial crisis, many volatility hedge funds have cut down or eliminated their OTC exposure entirely. Most now focus on listed options and have done much to eliminate counterparty risk. Volatility funds first attracted investors because volatility represented an uncorrelated play. It was obvious from an early stage that managers who could consistently trade volatility as an asset class would represent a good diversification benefit for a portfolio of hedge funds. As market volatility picks up, investors will also then focus on volatility funds in the expectation that this method will yield superior returns. Investor knowledge about the diversity of available strategies remains limited with a tendency to bracket all volatility funds together under the same analytical umbrellas, although their sources of return can be quite diverse.

There is increasing awareness of the need for volatility-based investments to be diversified across multiple markets and sectors. The fact that volatility funds will tend to make more money during periods of higher volatility make these funds attractive as a portfolio hedge against losses in other strategies. The increased use of exchange - traded options contracts make the funds more transparent and easier to price, yet another boon from an investor perspective. Traders of volatility as an asset class are not seeing volatility leaving the market entirely, even during periods when markets are relatively quiet. The base volatility&mdashthe lowest point to which the VIX will typically sink&mdashis higher than it was pre-2008. Fundamental issues surrounding the global banking system, the Eurozone, and the US debt ceiling, along with a long period of deleveraging, means that opportunities for hedge funds in this space will continue. Investor interest will also remain high as a consequence. Related Articles on OPTIONS. This is a rebroadcast of OICs webinar panel. In this deep dive discussion, Frank Fahey (representing.

Roma Colwell-Steinke of CBOEs Options Institute joins Joe Burgoyne in a conversation about method . This is a rebroadcast of OIC&rsquos webinar panel where you can take a deep dive into options Greek. Host Joe Burgoyne answers listener questions about mini-options and investor resources. Then on Stra. FOCUS: The Best Money Ideas for 2018. FOCUS: Futures, Options, & Crytocurrencies. VectorVest, Inc. 2650 W. Market Street, Ste #1-A, Akron, OH 44333. Commodity Futures Trading Commission. Three Lafayette Centre, 1155 21st Street NW, Washington, DC 20581. AdviceTrade provides online communities for stock market traders to learn and interact.

AdviceTrade'. The new Firefox. Download Firefox — English (US) Your system may not meet the requirements for Firefox, but you can try one of these versions: Download Firefox — English (US) Your system doesn't meet the requirements to run Firefox. Your system doesn't meet the requirements to run Firefox. Please follow these instructions to install Firefox. Please follow these instructions to install Firefox. The best Firefox ever. Uses 30% less memory than Chrome. Truly Private Browsing with Tracking Protection. all things Firefox. If you haven’t previously confirmed a subscription to a Mozilla-related newsletter you may have to do so. Please check your inbox or your spam filter for an email from us. Advanced Install Options & Other Platforms. Download Firefox for Windows. Download Firefox for macOS. Download Firefox for Linux. Download Firefox — English (US) Your system may not meet the requirements for Firefox, but you can try one of these versions: Download Firefox — English (US) Your system doesn't meet the requirements to run Firefox.

Your system doesn't meet the requirements to run Firefox. Please follow these instructions to install Firefox. Options trader hedge fund pdf Disclosure Document (PDF Format) Selected Articles by Twenty-First Securities Authors. By Robert Gordon, Twenty-First Securities Corporation. It is a well-accepted fact that most hedge funds are often somewhat tax-inefficient. Gordon 2004 discussed what hedge funds could do to make their trading more tax-efficient. Here, we turn to a somewhat different question, highlighting a problem that most hedge fund investors will face even when their hedge funds employ such tax-friendly trading tools. Indeed, the answer to the apparently innocuous question of whether a hedge fund manager is classified as a trader or an investor could well be the burning issue for individuals investing in hedge funds. For most individuals, the “wrong” answer can cause taxes to be paid on “phantom” profits, and the IRS definition of “trader” may surprise you. Domestic hedge funds are traditionally set up as flow-through entities, partnerships or limited liability companies (LLCs). The purpose of this structure is to insure that profits are only taxed at the level of the investor, rather than potentially twice, as would happen if the funds were structured as corporations. But a flow-through entity paying high fees to the investment manager can inadvertently force its investors to pay tax on more income than they actually earn. In this brief article, we quickly review the nature of the problem and the reason why it is a topical issue at this time. We then discuss a variety of possible solutions, ranging from the characterization of fees, to wrap-vehicles and derivative contracts.

Note that no solution is absolutely bulletproof, but most address one or another of the aspects of the problem. Accounting for management fees. Management fees are taken as miscellaneous itemized deductions under Section 212. This type of deduction is only usable to the extent it exceeds 2% of the investor’s adjusted gross income. Once this hurdle is met, the deductible amount is added to other itemized deductions, which are then reduced by 3% of the taxpayer’s adjusted gross income. In addition, the deduction is totally disallowed for alternative minimum tax purposes. Because of these limitations, a substantial majority of the family offices and other large investors have no use for this type of deduction. And yet, the way in which the manager is classified can actually lead to hedge fund management fees becoming effectively non-deductible. For example, assume a distressed debt fund charges a base 2% management fee and then charges another 20% performance fee on the remaining profits. If this fund had a gross return of 15%, the net return to the investor would be 10.4%. Many hedge funds take the position that they are traders and that these management and performance fees are incurred in their business and deductible under Section 162. Thus the entity’s form K-1 reflects only taxable income of 10.4%. If the IRS took the position that the fund was an investor and not a “trader,” then the K-1 would reflect an investment income of 15% and 4.6% in miscellaneous itemized deductions.

If investors were not able to use those deductions, they would pay tax on 15% even though they only earned 10.4%. So what was thought to be a 10.4% pre-tax return, and thus a 6.76% after-tax return, is actually only a 5.15% after-tax return. These calculations use a 35% federal tax rate, but are before state and local taxes are taken into consideration. For a New York City resident, state and local taxes can lower the return to less than 4%. Why Be Concerned Now? We believe this problem could well surface sooner rather than later because the IRS has “teed up” the issue in instructions to its agents auditing hedge funds. In its “Audit Technique Guide to Partnerships” ( irs. govpubirs-mssppartnershipsatg12-16.pdf ) , released in 2003, Chapter 12 deals with hedge fund issues. This chapter specifically instructs IRS agents to challenge trader status. Attorney Roger Lorence in the cover story of Derivatives Report September 2003 advises that “Everyone associated with hedge funds should pay serious attention to the IRS Hedge Fund Audit Manual. If a hedge fund is wrong on an issue, it is likely to affect every open year. Not only must the hedge fund file amended returns for the affected open years, but (at least in theory) all, or most, of the members will also have to file amended returns for the affected open years. Thus, if investor versus trader is the issue, the treatment of the fund's expenses as Section 162 expenses is incorrect.” The IRS Hedge Fund Audit Manual makes several assumptions. It instructs agents that one factor to consider is the "nature of the income from the activity - only short-term gains qualify as trading income… significant long-term capital gains, and even dividends and interest, are strong indications of an investor and not a trader.

" The Manual also instructs agents to examine a fund's offering document to determine whether it uses "capital appreciation" or "conservation of capital" as an objective, and contends that "objectives other than taking advantage of short-term market movements negate securities trader status." This reasoning probably comes from Liang v. Commissioner (1955) . A search of the case law on this issue is particularly disturbing because the government has been particularly stingy in granting trader status. Levin v. Commissioner, a 1979 U. S. Tax Court case, states, ”Although the Supreme Court has yet to find a taxpayer properly characterized as a ‘securities trader,’ it is clear that such a ‘businessman’ exists, given the proper facts.” And in Chen v. Commissioner, in 2004 , the Tax Court found that the investor traded rapidly enough to qualify as a trader, but it still denied trader status because the activity was not conducted for all 12 calendar months of the year. It would seem that a fund of funds would not be able to make a strong case for receiving trader status since it only allocates monies to other funds and holds the interests for a considerable period of time. In Mayer v. United States (1994), the Tax Court ruled that Mr. Mayer was an investor, not a trader, although he devoted his full time to monitoring the performance of several hired money managers doing over 7,000 trades per year. The reason was that “he personally did not engage in (or direct) the trading of stocks…”. A statistical arbitrage hedge fund that exclusively trades for short holding periods should be a trader. A convertible arbitrage hedge fund that holds its long positions for six months or more might be an investor, not a trader, even though it adjusts its hedge ratio of short sales more often. The hedge fund advisors that are aware of this problem advocate a few methods to sidestep it. Certain funds, for instance, take their performance fees as an “allocation of profits,” believing that this would make the fees reduce the capital account and not flow through to the K-1s as a deduction. But the IRS Partnership Audit Manual has something to say about this as well. Example 3 of Chapter 1 follows: “ A is a financial advisor who contracts with investor B to manage $20 million of assets. A and B form a partnership in which B contributes $20 million and A contributes zero and receives a 20% profits interest "in exchange for managing the assets.

" … the partnership has $4 million of earnings, and A receives $800,000 as his distributive share of partnership income.” Roger Lorence in the same article in Derivatives Report summarized the IRS view: “The Manual contends, citing no authority on point, that Section 707(a)'s application leads to re-characterization of the partnership arrangement as a disguised fee arrangement, with the $800,000 distributive share as self-employment income to A and Section 212 expense to B, not a Section 162 business expense.. The Manual's chief contention is that A has no risk of loss, and therefore, the arrangement is that of compensation for services. The Manual appears to be implicitly relying on Treasury's failure (after nearly 20 years) to issue regulations under the "disguised services" prong of Section 707. See Reg. 1.707-2, "Disguised payments for services." The regulation is "reserved" (meaning that its contents are blank). The Manual's attempt to convert any profits interest into a disguised fee--because the same economic result could be achieved through a fee--is an attempt to negate much long-standing law. Realizing Only Net Profits. Recently, it has been reported that a major accounting firm (one of the “final four”) has been suggesting that a domestic fund do nothing more than invest in the offshore entity, usually formed as a corporation in a tax haven. With this approach, any fees are charged to the offshore corporation before the domestic entity level. This solution seems both simple and effective. If the offshore fund makes a Qualified Election Fund (QEF) Section 1295 election, then only net profits earned at the offshore fund will flow through to the domestic fund at the end of each year.

These two ideas are executed at the level of the hedge fund itself. If neither is employed by the fund an investor owns, there are solutions at the investor level as well. One possibility would be to invest in a private placement life contract i that in turns invests in your chosen hedge funds. This entails its own set of costs, risks and benefits ii . The costs usually necessitate a long holding period and the net profits are realized as ordinary income taxed at the maximum rate (whatever that tax rate may be at the time). Ironically, the “plebian” mutual fund is specifically granted relief on this issue. A mutual fund must distribute its realized gains each year or face a corporate tax, but those distributions come exclusively from net profits. There are now a good number of mutual funds employing hedge fund strategies, and, according to the Center for International Securities and Derivatives Markets at The University of Massachusetts they are doing a good job iii . U. S. investors can invest in an offshore entity usually reserved for foreigners and U. S. tax-exempt organizations concerned with the tax on Unrelated Business Income (UBTI). With this approach, profits are realized net and quite possibly enjoy large tax savings at the state level as well iv . Investors can also buy into the payoff pattern of their desired hedge funds by entering into derivative contracts designed to mimic the performance of those funds. For instance, a total return swap or forward contract on a hedge fund would only pay off on the investment’s net profits.

Admittedly this method would flunk IRS Section 1260 so that any profits that are taken can not be long-term gain, but this would not affect the desired goal of only paying tax on net profits. For investors looking to turn their net profits into long-term gains, two strategies might be considered. The first is a call option on a fund of hedge funds (or fund itself if one can get a derivatives dealer to issue one). A simple call option should pass the tests of Section 1260, but some of the more esoteric structures might not accomplish this goal v Also, these options can seem expensive since one pays quite a bit to limit how much one can lose on one’s hedge fund investment. For those willing or wanting to invest in the hedge fund sector by way of indexes, one also sees the opportunity for long-term gains on only net profits. A “bullet” total return swap or forward would capture the returns on a chosen hedge fund index and seemingly work within Section 1260, with gains not needing re-characterization and therefore staying as long term gains vi . In short, though the investor or trader status of a hedge fund is a serious concern, it is still possible to manage around it. Yet, the main issue is that investors must be aware of the problem and able to take the steps required to address it before they wake up a number of years from now, finding it necessary to amend their returns and, most probably, pay additional taxes. These additional taxes indeed might substantially reduce the attractiveness of the investment they had made. i Several authors have substantially commented on these tools and can offer an interesting perspective on a costbenefit analysis. Cole, Brad F., and Christine M. Kailus. “Private Placement Life Insurance: The New Alternative in Insurance.” The Journal of Wealth Management , Winter 2002, pp. 27-33. Gordon, Robert N. “Making Hedge Funds More Tax-Efficient.” The Journal of Wealth Management , Summer 2004, pp. 75-80. Gross, Phillip. “Tax Planning for Offshore Hedge Funds – the Potential Benefits of Investing in a PFIC.” The Journal of Taxation of Investments, Winter 2004, pp. 187-195.

Manzke, Sandra L. “Private Placement Life Insurance.” The Journal of Private Portfolio Management , Summer 1999, pp. 45-48.