# Glass v. Commissioner

> United States Tax Court · November 17, 1986 · 87 T.C. 1087

URL: https://www.frixlaw.com/law-library/cases/4512421

## Case

- **Full name:** Barry S. Glass and Shirley P. Glass, <sup id="fnr_fnote1"><a href="fn_fnote1" id="">1</a></sup> v. Commissioner of Internal Revenue
- **Court:** United States Tax Court
- **Decided:** November 17, 1986
- **Citations:** 87 T.C. 1087; 87 T.C. No. 68; 1986 U.S. Tax Ct. LEXIS 166
- **Precedential status:** Published
- **Opinion:** Opinion of the court by Nlms
- **Judges:** Nims,Goffe,Chabot,Whitaker,Korner,Shields,Hamblen,Clapp,Swift,Parr,Wells,Gerber
- **Cited by:** 157 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/4512421

## How later opinions describe it (automated extraction)

- noting that in determining whether a transaction "lacked economic substance and was therefore a sham", "we are here focusing our attention not on questions of fact but on a question of law"

## Opinion text

NlMS, Judge: In these consolidated cases, respondent determined aggregate deficiencies in excess of $61 million in petitioners’ Federal income taxes for the years 1975 through 1980. 2
Each of the petitioners in these cases entered into a series of transactions herein sometimes referred to for convenience as the London Options Transaction. The issues for decision are: (1) Whether the London Options Transactions are shams; and (2) if the transactions are not shams, whether they were entered into for profit under the standard set forth in section 108 of the Tax Reform Act of 1984. 3
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in Massachusetts at the time their respective petitions were filed: 18692-80, 19753-80, 20768-80, and 14968-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either New York, Connecticut, or Vermont at the time their respective petitions were filed: 13835-79, 1627-80, 9423-80, 9746-80, 9747-80, 9748-80, 10902-80, 11811-80, 12144-80, 19750-80, 19897-80, 19898-80, 4841-81, 11717-81, 11718-81, 12324-81, 19181-81, 20627-81, 23591-81, 24091-81, 24604-81, 24755-81, 26700-81, 27400-81, 27719-81, 30709-81, 31186-81, 31188-81, 31190-81, 31191-81, 31192-81, 31262-81, 31278-81, 31299-81, 31327-81, 1347-82, 1982-82, 2018-82, 3280-82, 3770-82, 7128-82, 10129-82, 10287-82, and 13415-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either New Jersey or Pennsylvania at the time their respective petitions were filed: 13142-80, 15770-80, 15771-80, 16558-80, 17351-80, 21188-80, 2459-81, 7214-81, 13809-81, 13810-81, 28496-81, 25066-82, 25070-82, and 25174-82.
Petitioners in the following docket numbers resided (‘or, if-corporations, had their principal places of business or offices) in either North Carolina or Maryland at the time their respective petitions were filed: 321-80, 6906-80, 12976-80, 17069-80, 22085-80, 22195-80, 5194-81, 6377-81, 6500-81, 6929-81, 7113-81, 7698-81, 8020-81, 8573-81, 8586-81, 9395-81, 10196-81, 11621-81, 11846-81, 11892-81, 11929-81, 12742-81, 13026-81, 13664-81, 14058-81, 14776-81, 20338-81, 22418-81, and 776-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Texas or Louisiana at the time their respective petitions were filed: 5544-79, 5395-80, 5396-80, 5397-80, 5398-80, 5399-80, 5400-80, 5401-80, 6315-80, 10721-80, 12901-80, 15592-80, 16656-80, 17117-80, 17457-80, 19492-80, 21817-80, 5540-81, 9926-81, 12841-81, 23475-81, 23544-81, 25348-81, 25349-81, 25877-81, 25879-81, 27633-81, 27634-81, 993-82, 3794-82, 5907-82, 5908-82, 11087-82, and 16285-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Michigan or Kentucky at the time their respective petitions were filed: 3565-80, 3566-80, 3568-80, 538-81, 7213-81, 2475-82, and 20983-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Illinois or Indiana at the time their respective petitions were filed: 15145-79, 16358-79, 9060-80, 10642-80, 10643-80, 11067-80, 11068-80, 11173-80, 11174-80, 11175-80, 11176-80, 11177-80, 11195-80, 11205-80, 11206-80, 11207-80, 11216-80, 11605-80, 11755-80, 11756-80, 11757-80, 12609-80, 13223-80, 17336-80, 19419-80, 20531-80, 3561-81, 4987-81, 6762-81, 6763-81, 6764-81, 7851-81, 7852-81, 8431-81, 8432-81, 8434-81, 8545-81, 9501-81, 12878-81, 13276-81, 13898-81, 13913-81, 15875-81, 18428-81, 20514-81, 23324-81, 25639-81, 29423-81, 706-82, 3408-82, 3432-82, 5442-82, 5957-82, 6839-82, 10622-82, 13667-82, 14309-82, 14310-82, 14311-82, 14312-82, 14313-82, 14314-82, 14315-82, 14731-82, 14732-82, 14733-82, 14959-82, 14961-82, 15058-82, 15073-82, 15094-82 15844-82, 15914-82, 16629-82, 16630-82, 16631-82, 4 16632-82, 17452-82, 17453-82, 17460-82, 20423-82, and 22783-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Missouri, Nebraska, Minnesota, or Iowa at the time their respective petitions were filed: 12417-80, 17810-81, 17838-81, 19173-81, 25880-81, 2299-82, 8074-82, and 10623-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Utah, Wyoming, Colorado, Kansas, or Oklahoma at the time their respective petitions were filed: 8146-79, 8147-79, 8148-79, 8153-79, 8156-79, 8157-79, 8163-79, 8720-79, 9118-79, 9698-79, 9699-79, 9700-79, 1243-80, 1339-80, 2872-80, 4000-80, 4036-80, 4174-80, 9084-80, 9443-80, 10660-80, 11739-80, 11745-80, 11748-80, 12029-80, 12030-80, 12197-80, 12204-80, 12207-80, 12213-80, 12219-80, 12221-80, 12224-80, 12232-80, 12233-80, 12236-80, 12246-80, 12247-80, 12249-80, 12254-80, 12255-80, 12261-80, 12265-80, 12266-80, 12267-80, 12273-80, 12274-80, 12610-80, 8150-79, -8151-79, 8152-79, 8158-79, 8160-79, 8161-79, 9457-79, 9580-79, 9590-79, 12157-79, 15591-79, 1142-80, 2875-80, 3279-80, 3705-80, 4567-80, 8587-80, 8905-80, 10929-80, 11017-80, 11737-80, 11781-80, 11782-80, 11952-80, 12198-80, 12199-80, 12203-80, .12214-80, 12216-80, 12218-80, 12225-80, 12226-80, 12229-80, 12237-80, 12238-80, 12241-80, 12250-80, 12252-80, 12253-80, 12262-80, 12263-80, 12264-80, 12268-80, 12269-80, 12270-80, 12619-80, 13125-80, 13162-80, 13199-80, 13540-80, 16204-80, 16319-80, 16556-80, 16557-80, 16560-80, 16563-80, 16681-80, 17148-80, 18137-80, 19395-80, 5 19396-80, 6 19664-80, 19665-80, 19666-80, 19669-80, 19670-80, 20078-80, 20079-80, 20292-80, 20293-80, 20295-80, 20296-80, 20297-80, 20298-80, 20299-80, 20362-80, 20522-80, 20697-80, 20699-80, 20700-80, 20701-80, 20703-80, 20770-80, 20771-80, 20847-80, 21035-80, 21036-80, 21037-80, 21039-80, 21126-80, 21127-80, 21128-80, 21129-80, 21130-80, 22511-80, 22512-80, 391-81, 537-81, 666-81, 667-81, 669-81, 670-81, 1233-81, 1563-81, 2029-81, 3001-81, 3003-81, 3004-81, 5123-81, 5237-81, 9845-81, 9940-81, 12219-81, 7 12806-81, 12827-81, 12828-81, 12838-81, 12847-81, 12850-81, 13132-81, 13938-81, 14134-81, 16702-81, 17452-81, 22409-81, 22412-81, 22904-81, 23123-81, 23124-81, 23322-81, 24207-81, 24208-81, 25047-81, 27176-81, 27177-81, 27223-81, 27224-81, 27225-81, 28431-81, 29252-81, 29646-81, 30640-81, 30641-81, 31348-81, 31349-81, 31350-81, 890-82, 3627-82, 7808-82, 14470-82, 14949-82, 14969-82, 15007-82, and 15788-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either Alabama, Florida, or Georgia at the time their respective petitions were filed: 4054-79, 10252-80, 11640-80, 11894-80, 12122-80, 14757-80, 15899-80, 19248-80, 20521-80, 22981-80, 2398-81, 12840-81, 15538-81, 24461-81, 1235-82, 2293-82, 3874-82, 13689-82, and 17463-82.
Petitioners in the following docket numbers resided (or, if corporations, had their principal places of business or offices) in either West Germany, Great Britain, Canada, or France at the time their respective petitions were filed: 12987-80, 16483-80, 16963-81, 17532-81, 18747-81, 19013-81, 23321-81, 28492-81, and 5074-82.
The remaining petitioners resided (or, if corporations, had their principal places of business or offices) in either California, Arizona, Idaho, Montana, Nevada, Washington, Oregon, Alaska, or Hawaii at the time their respective petitions were filed. 8
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly. The stipulation of facts and exhibits attached thereto are incorpoiated herein by this reference.
I. Introduction
A typical London options transaction entered into by a petitioner involved a 2-year series of commodity trades and employed either an option-straddle or option-hedge trading strategy. Under the more prevalent option-straddle trading strategy, a petitioner purchased and sold options for future delivery of a specified metal in the first year of the transaction. Shortly thereafter, identical offsetting positions were executed resulting in an expected ordinary loss and short-term capital gain in approximately the same amount for the first year. The short-term capital gain was then “rolled over” into either a short-term or long-term capital gain in the second year through the execution of a futures straddle.
All London options transactions entered into by petitioners were conducted through one or more of 17 foreign broker/dealers operating on the London Metal Exchange (LME). Substantially all of the transactions were conducted with the following six so-called “major” broker/dealers: Rudolf Wolff & Co., Ltd. (Rudolf Wolff), Competex, S.A. (Competex), Gardner Lohmann Ltd. (Gardner Lohmann), Amalgamated Metal Trading Ltd. (Amalgamated), Rothmetal Trading Ltd. (Rothmetal), and Commodity Analysis Ltd. (Commodity Analysis).
In the following section, a general description of the LME, the types of contracts traded, and the option-straddle and option-hedge trading strategies are presented. Then, each of the major broker/dealers and a representative London options transaction conducted by each of them are discussed in detail.
II. Background
A. The London Metal Exchange (the LME)
The LME, a commodity exchange located in London, England, was established in 1877. Cash, future, and option contracts in silver, copper, zinc, tin, and lead are all traded on the LME.
The LME maintains three categories of membership-individual, representative, and associate subscribers. Individual subscribers are primarily persons prominent in metal trading but temporarily unaffiliated with a member company. Representative subscribers, the most important group, trade on behalf of their companies or organizations directly in the “ring,” the part of the exchange where formal trading occurs. The third category of members, the associate subscribers, are entitled to participate in the market but may not trade directly in the ring. All members are subject to annual election.
Before a company can be represented by a ring-dealing subscriber, it must meet stringent financial requirements. A margin of solvency test which includes both a proof of net asset worth and an independent bank or parent company guarantee is required. In addition, a ring-dealing company must be incorporated in the United Kingdom and be subject to British company law. During the years 1975 through 1980, there were approximately 30 ring-dealing members of the LME.
Unlike its American counterparts (e.g., the New York Stock Exchange and the Chicago Board Options Exchange), the LME does not operate as a clearing house for trades. Rather, all transactions on or subject to the rules of the LME are executed on a principal-to-principal basis. Thus, in each of these consolidated cases, a petitioner who purchased an option or futures contract through a broker/dealer was, in effect, actually purchasing that contract from the broker/dealer. Conversely, the broker/dealers were the purchasers of contracts whenever petitioners sold contracts in executing a London options transaction.
Because the LME operates as a principal’s market, broker/dealers are legally obligated to fulfill their part of any contract entered into with either another broker/dealer or a customer. A broker/dealer normally thus will lay off 9 his trades; i.e., enter into an offsetting contract with another party. A broker/dealer who fails to lay off a trade is said to be running a position (taking a risk) in the market. The LME does not require broker/dealers to lay off trades.
Trading on the LME occurs in three different ways: Formalized ring trading takes place twice a day during morning and afternoon sessions. Each metal is traded twice during each session in 5 minute “rings.” After the close of the final ring of the morning session, the LME quotations committee announces the official buyers’ and sellers’ prices for the metals traded. The official prices are merely the last bid and offer prices prevailing at the close of the ring. The so-called “settlement price” is the official price for cash sellers of a particular metal.
The afternoon session is similarly conducted with each metal again being traded in two separate rings. The London Financial Times reports the closing price of silver for the afternoon session as the “LME close.” The closing prices of all other LME traded metals are reported as the “PM Unofficial.”
Kerb trading entails formalized trading by ring members (representative subscribers) for a period of 15 minutes following the close of both the morning and afternoon ring sessions. All metals are simultaneously traded on the kerb.
Inter-dealer market trading consists of all trading which is not done either on the ring or on the kerb. Approximately 80 percent of all LME trading occurs in the inter-dealer market. All inter-dealer trades are subject to LME rules.
Because the LME operates as a principal’s market, no accurate financial data summarizing the transactions entered into by the various broker/dealers exists. Trading volume can thus only be estimated. Although such estimates are reported in the London Financial Times, they do not reflect the substantial amount of trading activity which takes place on the inter-dealer market.
Another significant difference between the LME and U.S. commodity exchanges is the LME’s lack of limits on price changes for metals which are traded. Prices are free to fluctuate on the LME as market conditions dictate.
B. Types of Contracts Traded
1. Option Contracts
The three most common forms of options traded on the LME are call, put, and double options. A call option gives the holder (the buyer) the right to buy from the grantor (the seller or writer) a specified quantity of a commodity at an agreed upon price at any time before the option’s expiration date. The holder of a put option has the right to sell a specified quantity of a commodity at an agreed upon price to the grantor at any time before the option’s expiration date. A third type of option is known as a double option. The holder of a double option has the right to either sell or buy the underlying commodity at ,the agreed upon price by the option’s expiration date. A double option is in effect the combination of both a put and a call option.
An option contract is unique in that the holder has the right but not the obligation to purchase or sell the stated commodity at the agreed price. Thus, while the grantor of an option might appear to be subject to unlimited risk, the holder is never at risk for more than the cost of the option.
The price paid by the holder to the grantor to purchase an option is known as the premium. Each option contract contains a strike (basis) price, the agreed upon price at which the holder may exercise his right to either buy or sell the underlying commodity (depending on whether a call or put option has been granted). An option holder must déclare his intention to exercise the option before the option’s declaration date. An option holder’s failure to declare by the declaration date represents an abandonment of the option. Finally, the delivery date (or prompt date) is the date on which the underlying commodity has to be delivered if the option is exercised.
The minimum contract size or unit for each metal traded on the LME is referred to as a “lot.” Copper, lead, and zinc are traded in 25-ton lots. Tin is traded in 5-ton lots while silver is traded in 10,000 troy-ounce lots. Option premiums are expressed in pounds sterling (£) per ton except for silver, for which premiums are expressed in pences per ounce.
The declaration date of an LME option is normally 1 trading day prior to the delivery date for each month of the option’s existence. Thus, a 3-month call option granted on January 10 for delivery on April 10 (the delivery date), would have a declaration date ob April 7. The holder would have to declare his intention to exercise the call option by April 7 or the option would be treated as having been abandoned.
The so-called traditional LME option is known as a market option. The strike price of a market option is normally set at the current future trading price of the underlying metal. In addition, traditional LME options are usually traded for a specific delivery date — 1, 3, 6, 9, or 12 months forward from the day the option contract is made.
A second type of option traded on the LME is known as a traded or dealer option. Unlike traditional LME options, delivery dates of traded options are not tied to specific future dates. Moreover, the strike price of a traded option may be set at, above, or below the current future trading price of the underlying metal. As explained infra, the relationship between the strike price of a traded option and the market price of the underlying commodity will be reflected in the premium received for the option.
The primary difference between a traded option and a market option is flexibility, the former being far more flexible than the latter. Frequently, the holder or grantor of an option will want to “close out” his position prior to the option’s declaration date. To close out a position, an option holder or grantor simply enters into an offsetting contract, thereby extinguishing all of his rights or obligations.
The inflexibility of closing out a market option arises from the difficulty of entering into an offsetting contract with identical terms. Because the strike price of a market option is customarily set at the current market price of the underlying commodity existing at the time the option is granted, the holder or grantor will normally be unable to enter into an offsetting position if the price of the underlying commodity has changed at the time of the desired closeout. In addition, the relatively rigid setting of declaration dates for market options makes it difficult to later contract for an offsetting position.
A traded option, however, offers much greater flexibility. The holder or grantor of a traded option can easily enter into an offsetting position having the same strike price and delivery date. Of course, the premium paid or received by the holder or grantor for entering into an offsetting contract will reflect changes in underlying market conditions. Because the options involved in executing a London options transaction were intended to be closed out prior to their declaration date, petitioners in these consolidated cases predominately entered into traded option contracts.
As previously noted, the strike price of a traded option can be set above, below, or equal to the current forward price of the underlying commodity. If the strike price of an option, as compared to the current market price of the underlying commodity, is in favor of the holder of the option (e.g., a silver call option with a strike price of 300 pence per ounce when the current market price for silver is 350 pence per ounce), the option is said to be “in the money.” Conversely, an option is “out of the money” if the strike price of the option as compared to the current market price of the underlying commodity is in favor of the grantor (e.g., a silver put option with a strike price of 300 pence per ounce when the current price of silver is 350 pence per ounce).
In general, the amount of premium paid for an option is determined through negotiation and bargaining between willing buyers and sellers. Nevertheless, the premium paid for an option normally reflects two factors — an intrinsic value and a time value. An option’s intrinsic value measures the relationship between the strike price and the current price of the underlying commodity (i.e., if and to what extent the option is in or out of the money). The time value of an option relates to the amount of time remaining until the option expires (the declaration date).
Broker/dealers charge fees in the form of commissions for executing options transactions. The amount of and manner in which commissions are charged can vary significantly. For example, ring members normally trade “net” with each other. When ring members trade net, profits are made not from commissions but rather from the difference between the bid and offer price of the contracts being traded.
Between a broker/dealer and a customer (e.g., a petitioner in these cases), however, commissions are normally charged based on a percentage of the strike price of the option. In addition, broker/dealers generally levy commissions only on the opening contract; thus no commissions are charged on the later closing transaction. Furthermore, at various times broker/dealers sometimes trade net with individual customers.
As previously noted, trading on the LME occurs either on the ring, kerb, or inter-dealer market. Options, however, are generally not traded in the fast-paced environment of either the ring or the kerb because in addition to premiums there must also be negotiated the delivery dates and strike prices. Thus, the vast majority of options are traded on the inter-dealer market where buyers and sellers are afforded the time to reach agreement on the various components of an option contract.
2. Futures Contracts
A futures (or forward) contract requires the buyer to receive and seller to deliver a specified quantity of a given commodity at some future date. As with options, the delivery (or prompt) date is the agreed upon future date on which delivery of the commodity is due. Selling short (or taking a short position) refers to the sale of a futures contract while buying long (or taking a long position) denotes the purchase of a futures contract.
Although a future’s contract is, of course, legally binding between the principals involved, actual delivery of the underlying commodity rarely occurs. Rather, like traded options, a futures contract is normally closed out before actual delivery occurs by entering into an offsetting contract with identical terms.
On the LME, futures contracts for metals are traded for delivery from the current date through 3 months forward, except for silver, which is traded from the current date through up to 7 months forward.
The future price of a commodity will, of course, either exceed, equal, or be less than the cash (or “nearby”) price of that commodity. In a normal market, the future price of a commodity is greater than its cash price. The difference between the two prices is known as the “contango.” The contango represents the cost of holding a commodity and thus is primarily related to prevailing interest rates. Warehouse and insurance costs are also reflected in a commodity’s contango.
Occasionally, a shortage in a commodity occurs, resulting in the cash price being greater than the future price. In such a situation, a “backwardation” is said to exist.
C. Straddles
A straddle consists of the simultaneous holding of a long position (a purchased contract) of a commodity for delivery in a future month and a short position (a sold contract) for the identical amount of the same commodity for delivery in a different future month. The long and short positions are commonly referred to as the legs of the straddle. Both option and futures contracts (or combinations of both) may be used in establishing (putting on) a straddle.
The legs of a straddle may be entered into simultaneously, i.e., each leg may be purchased and sold at the same time on the same day. In addition, a straddle may be established by separately executing the legs at different times. Similarly, the legs of a straddle may be closed out (i.e., offsetting contracts purchased and sold) either simultaneously or separately.
A switch transaction occurs when the holder of a straddle liquidates (i.e., closes out) one leg of the straddle and replaces the liquidated leg by either purchasing or selling (depending on whether a long or short position was liquidated) an identical quantity of the same commodity for delivery in a different month.
The potential for profit from a straddle arises from changes in the price differential (hereinafter sometimes referred to as the spread) between the legs of the straddle. A straddle in which the long position is held in a month farther out than the short position will increase in value if the price differential between the legs widens and will decrease in value if the price differential narrows. Conversely, a straddle in which the short position is held in a month farther out than the long position will increase in value if the price differential narrows and will decrease in value if the price differential widens.
As previously noted, the legs of a straddle are not always either put on or closed out simultaneously. When a short or long position is not held in a straddle configuration (i.e., the position is unhedged), the potential for profit arises solely from the risk that the value of the position held will increase or decrease.
Initial margin (or initial deposit) is the amount of money which a broker/dealer may require from a customer in order to initiate trading. Margin payments provide insurance to broker/dealers that losses incurred in a customer’s account will be met. Except for certain long-term silver futures contracts, there was no LME requirement during the years at issue as to payment of initial margin. A broker/dealer thus might begin trading for a customer without having received any initial margin if the broker/dealer believed that any future funds due from the customer would be forthcoming.
Although the amount of initial margin is subject to negotiation, it is normally based upon a percentage of the value of the outstanding futures contracts. Initial margins for a straddle are generally lower than for unhedged trading (i.e., open positions) because of the substantial reduction in a customer’s exposure in a straddle investment.
Maintenance margin (or margin where the term “initial deposit” is used) is the amount of funds, if any, that a broker/dealer might require a customer to pay into his account after trading commences. The payment of maintenance margin, like initial margin, is negotiable.
Broker/dealers periodically value the open positions in a customer’s account in order to determine whether the payment of maintenance margin is required. This valuation procedure, undertaken daily by most broker/dealers, is known as marking to market. The most recent market prices and spreads are generally used in marking to market a customer’s account.
After a customer’s account has been marked to market, and all relevant debits (e.g., losses on closed positions) and credits (e.g., previous margin deposits) have been taken into account, the net equity in a customer’s account can be determined. A customer’s net equity thus approximates the amount of funds a customer would receive (or pay, if the net equity were negative) if all open positions in the account were immediately closed out. If a broker/dealer believes insufficient net equity exists in a customer’s account the customer may be required to pay a maintenance margin.
The LME does not require or regulate the charging of commissions on futures contracts. Typically, though, commissions are charged based on a percentage of the contract price. 10 Commission percentages generally range from one-sixteenth of 1 percent to one-fourth of 1 percent per leg of each transaction. Commissions might be charged on the opening or closing transactions, or partly on both. As previously noted, ring members frequently trade net with each other without charging commissions.
Frequently customers provide broker/dealers with the discretionary authority to trade on their behalf. Broker/dealers generally attempt to lay off their trades (see discussion, supra) when they conduct discretionary trading since the laying off of trades is essential in order to avoid a possible conflict of interest with a customer. When discretionary trades are laid off, broker/dealers cannot, by definition, profit on the market movement of the contracts entered into with customers. Thus, the commissions charged for executing the trades are the broker/dealers’ sole source of profit.
III. The London Options Transactions
A. In General
In the above section we have set forth a broad description of the LME and the types of contracts traded thereon. We turn now to a description of the actual transactions at issue in these consolidated cases. As previously noted, a typical London options transaction took place over a 2-year period in the form of either an option straddle or an option hedge. An option-straddle transaction, 11 the more prevalent trading strategy, was initiated by the following combination of trades in the first year of the transaction:
(1) An option straddle was put on, consisting of the simultaneous purchase and sale (grant) of either a call or put option (or both), for identical quantities of the same commodity with different delivery dates; and
(2) A futures straddle was also put on, consisting of the simultaneous purchase and sale of futures contracts for identical quantities of the same commodity with different delivery dates.
Shortly after the option straddle was put on, the legs would be closed out through the purchase and sale of identical offsetting positions. The premium (purchase price) paid to buy an offsetting option which closed out the sold (granted) option would exceed the premium that had been received on the granted option, resulting in an overall net loss on the sold option leg of the straddle. Conversely, the premium received on the sale of an offsetting option which closed out the purchased option would exceed the premium that had been paid for the purchased option, resulting in an overall net gain on the purchased option leg of the straddle. The net loss and gain, which were approximately equal, would be reported as am ordinary loss and short-term capital gain for the first year of the transaction. Since the expected tax result in the first year was generally an ordinary loss, such loss could be used to offset ordinary income from unrelated sources.
Next, in a switch transaction, the so-called loss leg of the futures straddle would be closed out through the purchase (or sale) of an identical offsetting position and replaced by a new position with a different delivery date. (Because an inverse relationship normally exists between the legs of a futures straddle, one leg will have an unrealized loss while the other will have an unrealized gain.) The net loss on the closed leg of the futures straddle would be reported as a short-term capital loss in the first year of the transaction and would approximately equal the short-term capital gain incurred on closing out the purchased option position.
The final step of a typical option-straddle transaction occurred in the subsequent year, although not earlier than 6 months after the switch. Both legs of the futures straddle would be closed out by offsetting trades, resulting in a gain approximately equal to the loss incurred on the switch transaction in the previous year. The gain incurred would be reported as either a short-term or long-term capital gain in the second year of the transaction.
The second trading strategy employed by broker/dealers was the option-hedge transaction. In an option-hedge transaction, the sale of a call and/or put option was hedged by the purchase of a futures contract (to hedge the call) and/or the sale of a futures contract (to hedge the put). Shortly thereafter, the option positions would be closed out at a net loss through the purchase of an identical offsetting call and/or put option. Simultaneously with the purchase of the closing option positions, futures contracts would be executed to hedge the previously purchased and/or sold futures, thus forming one or more futures straddles. Finally, in the following year, thé futures straddles would be closed out at a gain approximately equal in amount to the loss incurred on the sold options.
Because both the option-straddle transaction and the option-hedge transaction strategies resulted in a capital gain in the second year of the transaction, many petitioners attempted to defer the gain (and possibly convert it into long-term gain) to the subsequent year by engaging in a rollover transaction. A rollover transaction simply entailed putting on another futures straddle in the second year of the transaction, subsequently closing out the loss leg in a switch, and then closing out the straddle at a gain in the following year.
B. Representative Transactions
1. Background
Each of the petitioners in these consolidated cases entered into one or more London options transactions. All of the trades comprising a London options transaction were executed for petitioners by broker/dealers on a discretionary account basis. Consequently, all decisions regarding aspects of a transaction (e.g., types of commodities and contracts traded) rested. with the broker/dealers. In accordance with general LME rules, all London options transactions were executed on a principal-to-principal basis between petitioners and their respective broker/dealers.
The marketing and promotion of the London options transactions in the United States were conducted by persons known as finders. A finder would explain the London options transaction to a potential customer and then transmit money and documents to a broker/dealer if the person wished to engage in a transaction.
Broker/dealers did not require petitioners to submit financial statements either prior or subsequent to opening a trading account. In addition, the amount of funds remitted to the broker/dealers by petitioners was agreed upon at the time of or prior to entering into a London options transaction. Finally, petitioners in every case received nominal or no funds back from the broker/dealers with whom they dealt.
2. Actual Transactions
a. Introduction
All but a handful of the London options transactions at issue in these consolidated cases were conducted through the following six so-called major broker/dealers: Competex, Rudolf Wolff, Gardner Lohmann, Amalgamated, Commodity Analysis, and Rothmetal. As previously discussed, each of the broker/dealers employed either an option-straddle or option-hedge trading strategy. Rudolf Wolff, however, traded both option straddles and option hedges for its customers. In addition, Gardner Lohmann and Amalgamated London options transactions occurred in tandem with Gardner Lohmann’s executing the option trades and Amalgamated’s executing the futures trades for petitioners. Thus, hereinafter the Gardner Lohmann and Amalgamated London options transactions are sometimes collectively referred to as the Gardner/Amalgamated transactions.
Below, each of the broker/dealers, their particular trading strategies, and representative transactions of petitioners who traded with them are discussed.
b. Broker/Dealers Employing the Option-Straddle Trading Strategy
i. Competex
(A) In General
Competex, a Swiss corporation (and thus not a member of the LME), was incorporated on April 14, 1976. All of Competex’s trading records were maintained at its headquarters in Geneva, Switzerland. At the time of trial, Competex was in voluntary liquidation.
Sometime in 1976, James Gourlay (Gourlay) became employed as a manager of Competex under a verbal contract. Gourlay had extensive experience in commodity trading, including options. Prior to 1971, Gourlay was a partner in and representative subscriber for Rudolf Wolff. In 1971, Gourlay became an individual subscribing member of the LME after leaving Rudolf Wolff to form Ingleram Investments, Ltd. (Ingleram). Gourlay continued to operate Ingleram while he was employed as a manager at Competex.
As manager for Competex, Gourlay employed an option-straddle trading strategy for the approximately 265 petitioners who had discretionary accounts with Competex. Between January and September 1976, option straddles were executed for a substantial majority of petitioners who traded with Competex. Initially, simultaneous put and call options were bought and sold by petitioners for identical quantities of the same commodity for different delivery dates. Subsequently, all of the option positions were closed out through the purchase of offsetting positions. All of the granted options were closed out for a net loss, while the purchased options were closed out for a net gain.
Although Gourlay intended to earn a net economic profit for petitioners dealing with Competex through changes in the spread, he was aware that certain favorable tax consequences resulted under existing American tax law for losses incurred on granted options. Thus, after learning that legislation ending such favorable tax treatment had been enacted (see discussion infra), Gourlay ceased using the option-straddle trading strategy.
Gourlay’s trading strategy also utilized futures straddles. For a substantial majority of petitioners who traded with Competex, a futures straddle with a 1-month spread was put on in early November 1976. The sold leg of the futures straddle had a delivery (prompt) date during the last week of August 1977, while the bought leg had a delivery date during the last week of September 1977.
Competex subsequently executed a total or partial switch in early December 1976 for each straddle. In a total switch, the entire bought leg was closed and replaced by a new long position for the same quantity with a delivery date in the last week of October 1977. In a partial switch, only a portion of the bought leg was closed and replaced. Thus, all straddles after a total switch had a 2-month spread between legs, while the straddles undergoing a partial switch had combined 1- and 2-month spreads.
All of the 1-month spreads were closed out during the last week of April 1977. Then, on August 9, 1977, Competex closed out the long positions which had been put on during either the total or partial switch. The short positions were thus left open. On August 11, 1977, the short positions were closed, thus concluding the London options transactions executed by Competex.
Each of those petitioners’ London options transactions which were handled by Competex were executed by Competex at prevailing market prices. Neither Gourlay nor anyone acting under his direction or control artificially assigned prices.
Gourlay never personally placed any of petitioners’ trades. John Pitcher, who was employed by Gourlay, was responsible for the actual execution of trades and related paperwork. As noted above, Competex did not always simultaneously execute the legs of straddle transactions.
For the majority of petitioners who traded with Competex, Gourlay agreed to limit their losses to the amount of initial margin deposited. Competex charged commissions for executing transactions in a variety of ways, including charging the entire commission on the opening or closing transaction, charging half the commission on both the opening and closing transaction, or trading net. 12 All trades executed by Competex for petitioners were laid off by placing orders through ring-dealing members of the LME, including Rudolf Wolff, Gourlay’s former employer.
Verbal authorization to trade discretionary accounts on behalf of petitioners was frequently given to Gourlay by finders. In return, the finders were compensated with a percentage of the commissions earned by Competex. The following promotional material describing the option-straddle trading strategy employed by Competex was sent by finders to prospective customers:
You may have some interest in a tax shelter which we are recommending to some of our clients which has extremely high potential benefits. It has the following attributes:
1. It is highly leveraged. For a $3,000 investment, a $25,000 1976 ordinary deduction can be acquired. That is the smallest amount which is available. However, greater write-offs are available with corresponding larger investments on an 8.3 to 1 ratio.
2. The economic risk is limited. It is a hedging transaction in silver where parity between monthly contracts is an historical fact and which when accomplished by a knowledgeable member of such exchange, the chance of overall loss is slight. However, the premiums and commissions for handling the transaction approximately equal the original investment.
3. Eighty-eight percent (88%) of the ordinary deduction taken in 1976 (the deduction less the original investment) will be recovered for tax purposes in 1977 but at capital gains rates. It is also possible to shelter the recovery by an additional transaction to take place in 1977. To someone who has capital loss carry forwards, the benefits are even greater.
Assuming a taxpayer in the 50% bracket, the tax consequences in 1976 are as follows; also assuming a $12,000 original investment and no shelter of the recovery in 1977:
1976
Amount invested = $12,000
Ordinary deduction = 100,000
Tax savings (50%) $50,000
1977
Capital gain 88,000
Tax (25%) 22,000
Tax savings from overall transaction 28,000
Less premiums and commissions 12,000
Economic gain 16,000
The same taxpayer could shelter the capital gain recovery follows: in 1977 as
1976
Amount invested now for 1976 12,000
Amount invested now for 1977 9,600
Ordinary deduction 100,000
Tax savings 50,000
1977
Ordinary deduction from $9,600 investment 80,000
Tax savings $40,000
Capital gain (1976 recovery) $88,000
Tax (22,000)
Capital gain (1977 recovery) 70,400 (17,600)
Tax savings from overall transaction 50,400
Less premiums and commissions 21,600
Economic gain 28,800
The economic gain for a 70% taxpayer with the same investment of $21,600 would be $48,960.
This type of shelter has been available for some time but over the last several months we have hesitated to recommend it to clients because of pending legislation before Congress to eliminate it and the possibility that said legislation might be applied retroactively. The House Ways & Means Committee has now acted by passing HR 12224 to remove the shelter but said legislation will be effective July 1, 1976. Thus, there are about ten days within which to act.
The transactions involve the purchase and sale of options. It is possible to deal in securities or commodities on varying exchanges but the shelter which we are suggesting you consider is handled on the London Metals Exchange through one of its members, Rudolf Wolff & Company of London and its affiliate company, Competex S.A. of Geneva, Switzerland[ 13 ]
We are acquainted with reputable people in the States who are involved in perfecting the transactions contemplated and who have spent a considerable amount of time in London establishing the contacts for handling the transactions. They will handle the transmition[sic] of the investment to Competex, the communication of the desired timing of tax effect to London, and will supply the investor with a schedule setting forth the tax consequences for tax reporting purposes.
The reasons for using the London Metal Exchange are three-fold:
1. A highly leveraged investment is available; in this case 8.3 to 1.
2. The premiums and commissions are negotiable; in this case 12%; an amount equal to the original investment.
3. Silver options and contracts are written on a daily basis, thus avoiding wash sale treatment.
Of course, all tax shelters are subject to attack by the IRS but there are private IRS rulings in existence approving the basic ordinary loss treatment. The transaction might be attacked by the IRS as a wash sale but that is unlikely because of the daily contracts on the London Exchange. It appears likely that the IRS will have less incentive to attack this shelter as a sham transaction since, if the proposed legislation is passed, as of July 1, it will no longer be available.
(B) Representative Competex Petitioner
The parties agreed that the options and futures trades of Dr. Judson Davison (Davison), docket No. 1132-80, were representative of the London options transactions entered into by petitioners who traded with Competex.
Competex initiated Davison’s London options transaction with a call option straddle on June 28, 1976. 14 On that date, Davison purchased a call option for 34 lots of silver (340,000 troy ounces) at a strike price of 299 pence per ounce for delivery on November 5, 1976. 15 Competex charged Davison a premium of 3.4 pence per ounce and a commission (based on the strike price) of .1875 percent for the option. Competex thus debited Davison’s account £13,466.13. 16
Davison put on the other leg of the straddle on the same date by selling (granting) a call option for 34 lots of silver at a strike price of 305.1 pence per ounce for delivery on December 9, 1976. 17 The option sold for a premium of 3.8 pence per ounce, less a commission of .1875 percent. Competex thus credited £10,974.99 to Davison’s account. 18
The next day, June 29, 1976, Davison entered into a put option straddle. He purchased a put option for 14 lots of silver at a strike price of 255.1 pence per ounce for delivery on November 11, 1976. 19 The option was purchased at a premium of 2.8 pence per ounce plus a commission of .1875 percent. Competex debited £4,589.64 to his account for the cost of the option. 20 Davison then sold a put option for 14 lots of silver at a strike price of 255.2 pence per ounce for delivery on December 15, 1976. 21 The option sold for a premium of 3.1 pence per ounce, less a commission of .1875 percent. Competex credited the net price of £3,670.10 for the sold option to Davison’s account. 22
On July 9, 1976, Davison’s June 28 call option straddle was closed out by the purchase and sale of offsetting positions. The bought leg was offset by the sale of an identical option (34 lots of silver at a strike price of 299 pence per ounce for delivery on November 5, 1976) for a premium of 18.5 pence per ounce. No commission was charged and Competex credited £62,900 to Davison’s account. 23 The sold leg was offset by the purchase of an identical option (34 lots of silver at a strike price of 305.1 pence per ounce for delivery on December 9, 1976) at a premium of 18.9 pence per ounce. Competex charged no commission and debited £64,260 to Davison’s account. 24
On July 19, 1976, Davison’s June 29 put option straddle was similarly closed out. The bought leg was offset by the sale of an identical option (14 lots of silver at a strike price of 255.1 pence per ounce for delivery on November 11, 1976) at a premium of 6.3 pence per ounce. Davison’s account was credited with the net price of the sold option of £8,820. 25 The sold leg was offset by the purchase of an identical option (14 lots of silver at a strike price of 255.2 pence per ounce for delivery on December 15, 1976) at a premium of 6.6 pence per ounce. Competex debited Davison’s account £9,240 for the transaction. 26 Competex charged no commissions on the closing transactions.
As a result of the option-straddle transactions, Davison incurred a combined loss on the granted options in the amount of £58,854.91 and a combined gain on the purchased options in the amount of £53,664.23, after commissions. 27 Davison reported an ordinary loss of $104,976 on the granted options for 1976. The gain on the purchased options was reported as short-term capital gain.
After closing out the option straddles, Competex put on a futures straddle for Davison’s account. On November 2, 1976, Davison sold 60 lots of silver for delivery on August 22, 1977, at a price of 307.6 pence per ounce. 28 Competex charged Davison a commission of .1875 percent on 14 of the lots sold, resulting in a net credit to Davison’s account of £1,844,792.60. 29 On the same day, the other leg of the straddle was put on with Davison purchasing 60 lots of silver (again in two separate purchases of 14 and 46 lots) at a price of 311.6 pence per ounce for delivery on September 23, 1977. Competex again charged a .1875 percent commission on only 14 of the lots purchased, resulting in a net debit to Davison’s account of £1,870,417.95. 30
On December 7, 1976, Davison closed out a portion of the loss leg of the straddle in a partial switch transaction. On that date, he offset a portion of the long position by selling 33 lots of silver for delivery on September 23, 1977, at a price of 293.7 pence per ounce. No commission was charged, and Competex credited £969,210 to his account. 31 Davison completed the switch by purchasing 33 lots of silver at a price of 296.7 pence per ounce for delivery on October 24, 1977. Competex charged no commission and debited £979,110 to Davison’s account. 32
As a result of the partial switch, Davison incurred a loss, including commissions, of £59,887.95 on futures trades in 1976. 33 Davison reported the loss as a short-term capital loss, thus offsetting the entire short-term capital gain of £53,664.23 on the purchased options.
Davison’s 1976 London options transaction was completed in 1977 with the following trades. On April 29, 1977, the balance of the November 2, 1977, purchased silver futures (27 lots) that had not been offset in the December 7, 1976, partial switch transaction were closed out. On that date, Davison sold 27 lots of silver for delivery on September 23, 1977, at a price of 285.2 pence per ounce price. Competex credited £770,040 to Davison’s account (no commission was charged). 34 The sold lots offset the lots purchased by Davison on November 2, 1976, resulting in an overall loss of £71,280, 35 which Davison reported as a short-term capital loss in 1977.
Davison then purchased 27 lots of silver for delivery on August 22, 1977, at a price of 281.6 pence per ounce. Competex charged no commission on the purchase and thus debited £760,320 to Davison’s account. 36 The 27 lots purchased partially offset the silver futures sold on November 2, 1976, resulting in a net gain of £69,392.55, after commissions. 37 Davison reported the gain as a short-term capital gain.
On August 9, 1977, the bought leg of the straddle put on by the December 7, 1976, partial switch transaction was closed out. In two separate transactions, Davison sold 20 lots of silver at a price of 267.3 pence per ounce and 13 lots of silver at a price of 267.4 pence per ounce, both for delivery on October 24, 1977. Competex credited £882,220 to Davison’s account (no commissions were charged). 38 The sold silver futures offset those purchased by Davison in putting on the partial switch transaction and resulted in an overall net loss of £96,890. 39 Davison reported the loss as a long-term capital loss.
Because the entire bought leg of the straddle was liquidated, the short position was left open. Two days later, on August 11, 1977, the sold futures were liquidated by Davison purchasing 33 lots of silver futures at a price of 260 pence per ounce for delivery on August 22, 1977. Competex charged no commission on the transaction, and thus debited £858,000 to Davison’s account for the cost of the purchase. 40 Davison reported the net gain of £157,080 from the offsetting purchase as a short-term capital gain. 41
Davison’s 1976 London options transaction thus resulted in the following gains and losses:
Net gain Gain
(loss) Year Description (loss) Commission
(£58,854.91) 1976 Ordinary loss-granted options (£56,240) £2,614.91
53,664.23 1976 Short-term capital gain-purchased options 56,240 2,575.77
1976 Short-term capital loss-futures trades (59,070) 817.95 (59,887.95)
1977 Short-term capital gain-futures trades Total 59,110 40 807.45 42 58,302.55 6,816.08 (6,776.08)
On June 10, 1976, 18 days before Competex put on Davison’s initial call option straddle, Davison paid $12,000 (£6,779.66) to Competex as initial margin on his account. No further maintenance margin was subsequently paid. As shown above, Davison incurred a net loss after commissions of £6,776.08 from entering into the London Options Transaction. Thus, the net equity in his account at the completion of the transaction was £3.58 (£6,779.66 initial margin less £6,776.08 trading loss). Competex did not return these funds to Davison.
ii. Rudolf Wolff
As previously noted, Rudolf Wolff traded both option straddles and option hedges for petitioners in these consolidated cases. Approximately 80 of the 96 petitioners who executed London options transactions with Rudolf Wolff engaged in option-straddle transactions, while the remaining petitioners employed the option-hedge strategy. All of the London options transactions put on by Rudolf Wolff, whether option straddles or option hedges, were initiated in 1975. The option-straddle transactions are discussed above, while the option-hedge transactions are presented infra.
Virtually all of the petitioners who engaged in an option-straddle transaction with Rudolf Wolff were introduced by and clients of Gourlay. 43 As noted above, Gourlay formed Ingleram in 1971 after the termination of his partnership interest in Rudolf Wolff. Before becoming employed as a manager at Competex, where he executed the option-straddle transactions described supra, Gourlay acted as a half-commission agent for Rudolf Wolff. In his capacity as a half-commission agent, Gourlay introduced clients to Rudolf Wolff who wished to engage in a London options transaction. Rudolf Wolff would execute the necessary trades (on a principal-to-principal basis), issue the related paperwork, and charge petitioners commissions for the option-straddle transactions. A portion of the commissions received by Rudolf Wolff subsequently would be paid to Gourlay.
Although Rudolf Wolff executed the trades of petitioners who engaged in option-straddle transactions, Gourlay ordered the trades and was responsible for the overall trading strategy. Gourlay employed an option-straddle trading strategy identical to that which he would later use at Competex. All relevant aspects of the two trading strategies (e.g., pricing and commissions) were similar. Thus, the representative option-straddle transaction of Competex petitioner Davison, described above, accurately reflects not only the Competex trading strategy but in addition the Rudolf Wolff option-straddle trading strategy. Consequently, an option-straddle transaction of a petitioner who traded through Rudolf Wolff is not presented. 44
iii. Gardner/Amalgamated
(A) In General
(1) Introduction
Approximately 175 petitioners in these consolidated cases entered into London options transactions with Gardner/Amalgamated. With few exceptions, all option trades were executed by Gardner Lohmann while Amalgamated performed all futures transactions. Initially, a petitioner would pay Gardner Lohmann to execute an option-straddle transaction. After putting on (and closing out) one or more option straddles, Gardner Lohmann would transmit the balance of any funds remaining in the account to Amalgamated for execution of a futures straddle. A more detailed discussion of the London options transactions put on by Gardner/Amalgamated is presented below.
(2) Gardner Lohmann
John Schrader (Schrader) incorporated Gardner Lohmann in October 1970. Schrader subsequently became the managing director of Gardner Lohmann and was primarily responsible for directing Gardner Lohmann’s trading. During the years at issue, Gardner Lohmann was not a ring-dealing member of the LME.
Richard P. Pearson (Pearson), a chartered accountant, began performing part-time accounting functions for Gardner Lohmann in 1973. In 1974, Pearson was appointed financial director of Gardner Lohmann. Pearson was responsible for financial and administrative matters at Gardner Lohmann until August 1976, when he left the company.
Schrader supervised the discretionary accounts of petitioners who entered into London options transactions with Gardner Lohmann. In that capacity, he employed the following option-straddle trading strategy which was similar to that used by Rudolf Wolff. Sometime in 1976, Gardner Lohmann would execute either a put or call option straddle (or both) for a petitioner. Shortly thereafter, the option straddle would be closed out through the execution of identical offsetting positions. As a result, a petitioner would incur an ordinary loss on the granted option and a short-term capital gain (of approximately the same amount) on the purchased option.
All option straddles put on by Gardner Lohmann were executed at prevailing market prices. Generally, Gardner Lohmann only charged commissions on the opening leg of an option straddle. Although commission rates were negotiable, Gardner Lohmann typically charged a rate of one-sixteenth per leg on the opening trade. Gardner Lohmann also agreed to limit petitioners’ losses to the amount of their initial margin.
Gardner Lohmann’s general practice was to lay off its trades; however, not all trades executed by them were laid off. Schrader was responsible for deciding whether a trade would be laid off.
Bell-Lewis was Gardner Lohmann’s principal finder in the United States for potential customers who wished to engage in a London options transaction. The following promotional material 45 was received by a petitioner who entered into a London options transaction with Gardner/Amalgamated:
INCOME CONVERSION AND DEFERRAL PROGRAM
This program is APPLICABLE TO BOTH INDIVIDUALS AND* CORPORATIONS. It is designed for those with high incomes and/or capital losses. The vehicle used for the program is the buying and selling of silver commodities - (puts, Calls and/or Contracts).
THE PROGRAM IS COMPRISED OF TWO STEPS
STEP I CONVERTS ORDINARY INCOME INTO CAPITAL GAIN.
STEP II DEFERS CAPITAL GAIN TAXABLE IN THE PRESENT YEAR TO POTENTIAL LONG TERM CAPITAL GAIN TAXED IN FUTURE YEARS.
STEP I
INCOME CONVERSION PROGRAM
This program is designed particularly for those with high incomes and capital losses. However, it can be effective even if a client does not have capital losses.
The vehicle employed is an Option Hedge! 46 ! with an optional tie-in to a Commodity Tax Straddle.
The Internal Revenue Service has recently rendered a series of rulings which if professionally applied can result in truly remarkable tax savings opportunities.
In part, one ruling states:
“If a writer of a call engages in a closing transaction by payment of an amount equivalent to the value of the call at the time of such payment, the difference between the amount so paid and the premium received by him is ordinary income or loss.”
Thus, in the case of the writer (or seller) of an option that is closed out prior to the expiration date ordinary income or loss results. In the hands of the holder (or buyer) an option is a capital asset and gives rise to capital gain or loss.
ILLUSTRATION:
WRITER:
Writes Call $10,000 premium received
Closes Call 10,500 premium paid
Ordinary Loss (500)
HOLDER:
Buys Call $10,000 premium paid
Sells Call 10,500 premium received
Capital Gain 500
QUESTION: WHAT IS THE RATIONALE FOR CONSIDERING AN OPTION WRITER’S CLOSING TRANSACTION AN ORDINARY TRANSACTION AND NOT A CAPITAL TRANSACTION?
According to the IRS ruling the closing writer is not transferring a “capital asset” within section [1221] of the Code and the closing transaction does not result in capital gain or loss because it does not involve a “sale or exchange”. What is involved is the receiving of a premium or the incurring of an expense to release the writer from a contractual obligation.
QUESTION: HOW DO I UTILIZE THE NEW RULINGS TO SERVE MY TAX PLANNING REQUIREMENTS?
You establish hedges in options whereby you purchase and write options for equal amounts of silver. Options would be set up with different expiration dates and possibly different striking prices.
For hedges employing CALLS, a rise in the price of the underlying silver would create a capital gain on the long side and an approximate offsetting ordinary loss on the short side.
For hedges employing PUTS, a drop in the price of the underlying silver would create a capital gain on the long side and an ordinary loss on the short side.
THE OBJECTIVE OF THE PROGRAM, ASIDE FROM THE PROFIT MOTIVE, IS TO ACHIEVE AN ORDINARY LOSS APPROXIMATELY OFFSET BY A CAPITAL GAIN.
QUESTION: WILL THE CONVERSION BE DONE IN ONE TRANSACTION?
In most cases a series of diversified Option Hedge transactions selected to benefit from short-term price spreads and fluctuations would be used.
QUESTION: WHAT HAPPENS SHOULD THE LOSS APPEAR ON THE LONG SIDE?
You would be generating ordinary income and capital loss. However, we anticipate the adverse tax effect will be absorbed in the total series of transactions and the net result should be ordinary loss and capital gains.
QUESTION: HOW MUCH TIME IS REQUIRED TO ACHIEVE THE DESIRED CONVERSION?
Actual time required depends upon the volatility of the market. A $100,000 conversion could be generated in a week or in a month. As a rule of thumb it is anticipated that the transaction would take from 15 to 45 days.
QUESTION: WHAT IS THE ESTIMATED COST AND RISK?
The total pre-tax cost discounting any profit potential for accomplishing the desired conversion would be dependant on amount of write-off desired and at what time of year you initate the program. This would include commissions, fees, and documentation.
Since at all times you are in a completely hedged position, long and short options for the same amount of silver, you are not subject to the ordinary risk of market fluctuations. You may, however, be subject to the risk of adverse spread variations. This would result when in the silver price movement the long and short option prices do not move uniformly up or down. This risk is far less than that incurred should you be either long or short an option and not be in a hedged position.
QUESTION: WHY IS [SIC] SILVER FUTURES USED RATHER THAN OTHER COMMODITIES?
Silver futures are used since historically the price fluctuation between various delivery months remains reasonably constant.
QUESTION: WHY IS THE TRANSACTION PERFORMED IN LONDON?
There are two primary reasons:
1. Exchange Guarantees - Commodity contracts traded in London are guaranteed by the Exchange on which the commodity is traded. Contracts traded in the United States are only guaranteed by the full faith and credit of the broker or dealer selling the contract.
2. Centralized Market Place - In London commodity contracts Eire traded on a central commodity exchange (e.g., silver is traded on the London Metal Exchange). This afford [sic] price stability, as well as fluidity and liquidity in transacting trades. In the United States commodity contracts are traded directly between hundreds of brokerage houses which restricts liquidity and increases price differentials.
QUESTION: IS THERE A LIMIT TO THE ORDINARY LOSS THAT AN INDIVIDUAL OR A CORPORATION CAN TAKE USING THIS PROGRAM?
No. While the amount of tax deduction based upon interest expense may be limited for an individual or corporation, there are no such limitations on ordinary losses realized from Option Hedges.
QUESTION: WHAT IS THE PROFIT POTENTIAL IN OPTION HEDGES?
The price relationship between two options in the same commodity with different expiration dates and/or different striking prices can fluctuate based on changes in the price of the underlying commodity. This change in the relative values between the options can give rise to a profit or a loss.
QUESTION: HOW CAN THE CAPITAL GAIN BE SHELTERED?
The gain generated by the Option Hedge will almost certainly be short-term and can be handled as follows:
1. For those with realized capital loss carry-forwards, long or short term, the gain can be offset dollar for dollar.
2. For those with unrealized capital losses the gain offers an excellent reason for realizing the loss, thereby releasing capital while recouping a large portion of the loss through tax savings.
3. For those without capital losses the Option Hedge would be used in conjunction with the Income Deferral Program, in which Tax Straddles are used to defer the short term capital gain and are structured to convert it into long term capital gain.
STEP II
INCOME DEFERRAL PROGRAM USING COMMODITY TAX STRADDLE
A Commodity Tax Straddle is the simultaneous purchase and sale of a like number of commodity future contracts for delivery in different months in the next taxable year. A rise in price would thus create a capital gain on the long side and an approximate offsetting capital loss on the short side. The reverse would occur on a drop in price.
The loss is realized in one tax period and the gain in the next. In this way the tax on the gain is deferred. For conversion from short-term to long-term gain the long position must be held for over six months and the gain must appear on the long side, which would occur only in a rising market.
QUESTION: HOW DO I PROTECT MY GAIN AFTER REALIZING THE LOSS?
By replacing the contracts covered to realize the loss with contracts for equal amounts of silver for delivery in the next taxable year but at the current market price.
QUESTION: HOW IS A COMMODITY TAX STRADDLE USED IN CONJUNCTION WITH AN OPTION HEDGE?
This becomes vital for the Taxpayer who does not have realized or unrealized losses available to offset the short-term gain generated by the Option Hedge.
For example, if in 1975 the Option Hedge creates an ordinary loss of $10,500 and a short-term gain of $10,000, the Commodity Tax Straddle would be used to create a $10,000 short-term loss in 1975 and a $10,000 short or long-term gain in 1976.
QUESTION: WILL CURRENT TAX REFORM PROPOSALS AND PRESENT TAX LEGISLATION ADVERSELY AFFECT THIS PROGRAM?
Main La Frentz & Co. and Eli Warach have researched this question in detail and it is their opinion that neither current tax reform proposals nor present tax legislation would affect the Program.
QUESTION: WHEN SHOULD I ENTER THE PROGRAM?
As early in the tax year as is possible for you to approximate your taxable income.
SUMMARY
QUESTION: COULD YOU SUMMARIZE THE PROGRAM FOR ME?
1. Dollars you would have paid in taxes can now be used for an additional year.
2. Capital losses can now be used to reduce ordinary income.
3. Income taxed at ordinary rates may now be taxed at the more favorable long term capital gain rates.
i.e. For individuals a maximum of 35%
For corporations a maximum of 30%
THIS IS JUST A SUMMARY OF THIS PROGRAM LIKE ANY INVESTMENT, YOU SHOULD CONSULT YOUR TAX, LEGAL AND FINANCIAL ADVISORS
WE ENCOURAGE YOU TO DO SO
(3) Amalgamated.
Amalgamated, located in London, England, was formed in 1975 as a wholly owned subsidiary of Amalgamated Metal Corp. Amalgamated trades only in metals and during the years at issue was a full ring-dealing member of the LME.
Between December 9, 1977, and May 30, 1980, Amalgamated owned a 40-percent investment interest in Gardner Lohmann. Amalgamated has never had a management interest in Gardner Lohmann.
Terrance McGuinness (McGuinness), a commodities trader at Amalgamated, supervised the Amalgamated team which traded futures straddles for petitioners engaging in London options transactions. As previously noted, Gardner Lohmann would transfer petitioners’ account balances to Amalgamated after executing option-straddle transactions. Amalgamated, under McGuinness’ supervision, would then execute futures straddles for petitioners to defer (and convert, if possible) the short-term capital gain realized on the option-straddle transactions. Although Amalgamated attempted to conduct all straddle trading simultaneously, it was not always able to put on (or close out) the legs of a straddle at the same time.
All legs of the futures straddles were executed at prevailing market prices. Amalgamated generally charged commissions of .1 pence per troy ounce on the opening leg (i.e., the leg with the nearer delivery date) of a straddle transaction. During the years in question, it was Amalgamated’s general practice to lay off all futures trades.
Bell-Lewis acted as a finder for Amalgamated. The following letter soliciting a futures straddle was sent by Bell-Lewis to an Amalgamated petitioner:
Dear [name]
Bell-Lewis has been requested by the trading firms in London to contact their clients concerning the possible deferral of capital gain taxes that the client might be liable for in the present tax year.
As you probably know, one of the auxiliary advantages resulting from the commodity option trading that your clients have been involved in has been the reduction of their ordinary income tax liability for 1976. However, the trading firms in London have found that many of their clients also have substantial capital gain liabilities that they should consider deferring into 1977 or after. Especially in light of the new changes on tax preferences in the 1976 Tax Reform Act. Such a deferral can be accomplished by a competent trading firm with minimal costs and risks by using certain trading techniques involving commodity future contracts.
You should contact your clients if you feel that they do have a capital gain problem at the present time.
If either you or your clients wish to discuss the possibility of deferring this tax liability to some future date, please feel free to contact our office for further discussion. Of course, as in the past, these clients will be dealing directly with London firms with all trading decisions made by them. The normal range of trading commissions involved in such a program is very minimal. Bell-Lewis will be acting merely in an administrative capacity.
Any program of this nature must be started as quickly as possible since there are only about 60 days left in the year. Please direct your inquiries to Mr. Wallace Willard, Assistant Vice-President, Bell-Lewis.
Enclosed you will find some illustrations which show the impact in the form of actual tax savings by using a capital gain deferral program.
Sincerely,
Bell-Lewis Associates, Inc. (S)Robert W. Bell President
P.S. Of course, do not limit contacting your client to only those that participated in the options trading programs. All clients with any type of capital gain problem would qualify.
(B) Representative Gardner/Amalgamated Petitioner
The parties agreed that the London options transaction entered into by Eddie H. Anderson (Anderson), docket No. 20543-80, was representative of the London options transactions executed by Gardner/Amalgamated.
Gardner Lohmann initiated Anderson’s London options transaction on August 26, 1976, with a put option straddle. 47 On that date, Anderson sold a put option for 24 lots of silver (240,000 troy ounces) at a strike price of 243.3 pence per ounce for delivery on November 25, 1976. 48 Gardner Lohmann purchased the put option from Anderson at a premium of 16.2 pence per ounce, less a commission of .0625 percent. Gardner Lohmann thus credited £38,515.05 to Anderson’s account. 49
The other leg of the straddle was executed (on the same date) by Anderson’s purchasing from Gardner Lohmann a put option at a premium of 6.4 pence per ounce for 24 lots of silver at a strike price of 238.4 pence per ounce for delivery on September 27, 1976. 50 Gardner Lohmann again charged a commission of .0625 percent, which resulted in a net debit of £15,717.60 to Anderson’s account. 51
The put option straddle was subsequently closed out 5 days later. On August 31, 1976, the sold leg of the straddle was offset by the purchase of an identical option (24 lots of silver at a strike price of 243.3 pence per ounce for delivery on November 25, 1976) at a premium of 21.8 pence per ounce. The bought leg was similarly offset by the sale of an identical put option (24 lots of silver at a strike price of 238.4 pence per ounce for delivery on September 27, 1976) at a premium of 12.4 pence per ounce. No commissions were charged on either closing transaction. Gardner Lohmann debited £52,320 (24 lots X 21.8 pence per ounce premium) to Anderson’s account for the offsetting purchased option and credited £29,760 (24 lots X 12.4 pence per ounce premium) to his account for the offsetting sold option. The net result to Anderson from closing the put option silver straddle was a £13,804.95 loss 52 on the sold (granted) leg and a £14,042.40 gain 53 on the purchased leg.
On August 31, 1976, the day Anderson’s put option silver straddle was closed, Gardner Lohmann executed a call option straddle in copper wirebars for Anderson. The copper wirebars straddle was put on in the same manner as the silver straddle, with Gardner Lohmann only charging commissions on the opening legs of the straddle. The straddle was closed out the following day (September 1, 1976) through the purchase and sale of identical offsetting positions. The net result to Anderson from entering into the copper wirebars call option straddle was a £14,376.52 loss on the sold (granted) option and a £11,183.31 gain on the purchased option. 54
Taking into account both the silver and copper straddles, Anderson incurred a £28,181.47 loss on the sold (granted) options and a £25,225.71 gain on the purchased options in 1976. 55 The gain and loss were converted into dollars at a rate of 1.7745 dollars/pound. Anderson consequently reported an ordinary loss of $50,008 on the sold options and short-term capital gain of $44,763 on the purchased options on his 1976 Federal income tax return.
Sometime prior to September 1976, Anderson made an initial margin deposit to Gardner Lohmann in the amount of $6,000. At the conclusion of his option trades, Anderson had $755 remaining in his account at Gardner Lohmann. 56 Gardner Lohmann forwarded these funds to Amalgamated for the futures straddle portion of Anderson’s London options transaction.
Amalgamated commenced the rollover transaction by putting on a futures straddle for Anderson on October 18, 1976. On that date, Anderson sold 45 lots of silver at a price of 288.7 pence per ounce for delivery on August 24, 1977. Amalgamated charged no commission on the sale. Thus £1,299,150 was credited to Anderson’s account. 57 Anderson then purchased 45 lots of silver for delivery on October 5, 1977, at a price of 293.4 pence per ounce plus a commission of .10 pence per ounce. Amalgamated debited Anderson’s account £1,320,750 for the purchase. 58
Seven days later, on October 25, 1976, Amalgamated closed out the loss leg of the futures straddle (which was on the sold side) by executing a switch transaction. Anderson offset the short position by purchasing 45 lots of silver for delivery on August 24, 1977, at a price of 295 pence per ounce. Competex charged no commission on the purchase, and thus debited £1,327,500 to Anderson’s account. 59 The switch was completed by Anderson’s sale of 45 lots of silver for delivery on September 21, 1977, at a price of 298.4 pence per ounce, less a .10 pence per ounce commission charge. Amalgamated made a net credit of £1,342,350 to Anderson’s account. 60
Anderson thus incurred a loss of £28,350 from closing out the short position. 61 After converting the loss into dollars (at a conversion rate of 1.5782 dollars/pound), Anderson reported a short-term capital loss in the amount of $44,742 on his 1976 income tax return. The short-term capital loss of $44,742 offset the $44,763 short-term capital gain that had been previously incurred on closing out the purchased options.
The following year, on September 12, 1977, Amalgamated completed the rollover transaction and closed out Anderson’s futures straddle. On that date, Anderson offset the entire bought leg of the futures straddle by selling 45 lots of silver for delivery on October 5, 1977. Anderson sold the 45 lots to Amalgamated in two separate transactions of 23 and 22 lots at a price of 259.2 and 259.3 pence per ounce, respectively, less commissions of .10 pence per ounce. Amalgamated credited the net sales proceeds of £1,166,170 to Anderson’s account. 62
Anderson then closed out the sold leg of the straddle by purchasing 45 lots of silver for delivery on September 21, 1977. The offsetting purchase again took place in two separate transactions of 23 and 22 lots, both at a price of 258.7 pence per ounce (no commissions were charged). Amalgamated thus debited £1,164,150 to Anderson’s account. 63
As a result of the offsetting purchases and sales, Anderson incurred a loss of £154,580 64 on the bought leg of the straddle and a gain of £178,200 65 on the sold leg in 1977. Anderson also entered into three separate straddles on January 25, April 5, and August 19 during 1977. Each of these straddles was closed out shortly thereafter on January 26, April 6, and August 24, respectively. 66 Anderson incurred a total net gain and loss (after commissions) of £57,560 and £53,310, respectively, from the three straddle transactions. 67
All of the gains and losses incurred by Anderson from completing the rollover transaction and executing the above three straddles were reported as short-term capital gains and losses, respectively, except for the £154,580 loss incurred on the long leg of the rollover straddle which was reported as a long-term capital loss. Thus, overall, Anderson incurred a gain from futures trades in the amount of £27,870 for 1977. 68
After completion of the futures straddle portion of his London options transaction, Anderson’s account balance at Amalgamated showed a balance of $2.54 owed to Amalgamated. 69 Amalgamated did not require Anderson to remit the funds due and thus closed his account on October 12, 1977.
A summary of Anderson’s 1976-77 London options transaction is as follows:
Year Description Gain (loss) Commission Net gain (loss)
1976 Ordinary loss-granted options (£27,315) £866.47 (£28,181.47)
1976 Short-term capital gain-purchased options 26,075 849.29 25,225.71
1976 Short-term capital loss-futures trades (28,350) (28,350.00)
1977 Short-term capital gain-futures trades Totals 32,880 3,290 5,010.00 6,725.76 27,870.00 (3,435.76)
iv. Commodity Analysis
(A) In General
Commodity Analysis was chartered as a commodity commission brokerage house in London, England. During the years at issue, Commodity Analysis had two subsidiaries, Commodity Analysis Trading and Chart Analysis. Commodity Analysis Trading traded and exported physical goods while Chart Analysis performed technical market analysis and acted as an investment advisory company.
David Monroe Anderson (Anderson) was the managing director 70 of Commodity Analysis from its inception until 1981, the year in which Commodity Analysis was sold to a British banking group. Anderson became an individual subscribing member of the LME in 1975 and has been an active commodity broker and trader since 1964.
During the years at issue, Commodity Analysis was not a ring-dealing member of the LME. Ten employees of Commodity Analysis were engaged in its trading and brokering operations, including option trading. Another three to four people were employed in the margin department. Commodity Analysis received annual commissions in excess of 1.5 million pounds sterling during 1975, 1976, and 1977.
Approximately 131 petitioners in these consolidated cases executed London options transactions with Commodity Analysis. Commodity Analysis put on two separate series of London options transactions during 1975-76 (hereinafter the 1975 series) and 1976-77 (hereinafter the 1976 series). Approximately 25 petitioners participated in the 1975 series while the remaining petitioners traded the 1976 series.
Although a general option-straddle trading strategy involving option and futures straddles was employed by Commodity Analysis, the identical trading strategy was not used in both the 1975 and 1976 series. For the vast majority of petitioners who entered into London options transactions with Commodity Analysis during 1975-76 (the 1975 series), Commodity Analysis executed an option straddle using double options. 71 Shortly thereafter, the option straddle was closed out resulting in an ordinary loss on the granted option and a short-term capital gain (in approximately the same amount) on the purchased option.
Concurrently with the execution of the option straddle, Commodity Analysis would put on a futures straddle. Sometime prior to 1976, Commodity Analysis would close out the loss leg of the futures straddle in a switch transaction, thus generating a short-term capital loss. Six months later, in 1976, the futures straddle would be closed out at a capital gain approximately equal to the capital loss incurred in the switch transaction.
For the 1976 series of London options transactions, Commodity Analysis used “ordinary” rather than double options in executing petitioners’ option straddles. In addition, while only silver was traded in the 1975 series, other metals, such as copper wirebars, were traded during the 1976 series. The final significant difference between the 1975 and 1976 series was the creation of a butterfly straddle in the 1976 series after the loss leg of the futures straddle was closed out in a switch transaction. 72
Anderson was aware that under American tax law, favorable treatment was accorded to losses on sold (granted) options and thus in both the 1975 and 1976 series he would incur losses on the sold options if possible. Anderson’s decision as to whether to employ double or ordinary options in executing the option straddles was based on whether he thought the market was in a vacillating stage (whereby double options were employed) or in a directional (upward or downward) phase (whereby ordinary options were used).
Commodity Analysis would sometimes begin trading a petitioner’s London options transaction before the receipt of initial margin if the client was well known to Commodity Analysis. In addition, because all trading was discretionary, Commodity Analysis would frequently agree with petitioners to limit their losses to the amount of initial margin deposited. Virtually all of petitioners’ trades were laid off by Commodity Analysis.
The majority of petitioners who dealt with Commodity Analysis were represented by an American company named London Commodity Options, Ltd. (LCOL). LCOL negotiated commission rates with Commodity Analysis on behalf of petitioners. For trades executed in the 1975 series, commissions were generally charged on the opening legs of the option and futures straddles. In the 1976 series, commissions were not charged on any of the individual trades but rather debit notes representing commission charges were issued to petitioners after the option and futures straddles were closed. The second debit note (issued after the futures straddle was closed) was always in the amount which brought the account balance to zero.
All Commodity Analysis transactions were executed at market prices and prevailing spread differentials. Commodity Analysis, however, did not always simultaneously put on or close out the legs of straddles for petitioners.
The following promotional material was received from a finder by a petitioner who entered into a London options transaction with Commodity Analysis:
AN INTRODUCTION TO LONDON COMMODITY OPTIONS
Over the years, many systems have been devised to take advantage of the high leverage, the volatility and the unlimited profit potential of the commodity futures market. Yet, with each of these systems the investor is left vulnerable to losses well beyond his original investment should the market go against him.
The only known method capable of setting an absolute limit on losses while still providing the potential for extraordinary capital gains is thru use of commodity Puts and Calls.
Many U.S. investors are familiar with Put and Call options in securities but are unaware that a large international market exists in similar options in commodities.
These options are traded in London and Paris in such world commodities as Cocoa, Sugar, Silver, Wooltops, Coffee, Copper, Lead, Zinc and Rubber. Like the futures contract they pertain to, options are traded by open outcry on their respective exchanges, thus providing high market liquidity.
Purchase of an option gives the buyer the right to control a futures contract for a specified period of time of up to 18 months. The cost of the option is the full extent of the investor’s financial commitment. He is never subject to a margin call. When the market moves in his favor, he has the right to exercise the option for a profit at any time prior to expiration date.
HOW PUTS AND CALLS WORK FOR ME
This market works in a very simple fashion and the brief explanation which follows will provide good understanding of its workings.
A CALL OPTION is the right to buy a futures contract at the current market price (Striking Price) in order to profit from an expected rise in the price of the commodity within the specified option time period. A profit is made when the commodity rises sufficiently to give your option a value which exceeds the cost (Premium) paid for it.
A PUT OPTION is the right to sell short a futures contract at the current market price in order to profit from an expected fall in the price of the commodity. Here a profit is made when the downward move is sufficient to give your option a value which exceeds the premium cost.
A DOUBLE OPTION is simply a back to back Put and Call in the same commodity in order to profit from market moves in both directions. It is used when large see-saw moves are anticipated.
If, during the life of the option, the market does not move sufficiently to give your option a value which exceeds its cost, a proportionate loss will occur. However, this loss cannot exceed the original premium cost. By contrast, those who trade the futures market directly can be hit with losses far in excess of their original investment.
TRADING AGAINST PUTS AND CALLS
The owner of an option also has the right to use it as collateral for taking a direct futures position against the option. This is called “HEDGING” and may be used to lock in an option profit if a market reversal appears imminent, or to capitalize on the many short term market moves which occur during the life of the option.
Here again there are no margin calls to contend with and only a nominal hedge fee is charged.
Profits and losses on closed out hedge positions must be settled immediately, whether thru account adjustment or cash payment.
Before entering a hedge position, you should review this carefully with your Account Executive.
HOW IS MY ACCOUNT MANAGED?
Since we deal in only 10 world commodities, we have a significant advantage in specialization.
Your Account Executive will recommend a portfolio based on intelligence from our highly respected London correspondents, knowledgeable independent advisory sources and our own review of market conditions. You will then be advised regularly on the status of your positions and given recommendations regarding exercising or hedging your options.
SUMMARY
Advantages of Investing In Commodity Puts & Calls
1. Unlimited profit potential in either upside or downside market.
2. Limited, pre-determined risk. (LIKE ANY INVESTMENTS IN COMMODITIES ONLY RISK CAPITAL SHOULD BE USED.)
3. No margin calls or forced liquidations.
*4. No reserve deposit required. The premium cost is your only outlay.
5. Tremendous money leverage on invested capital.
6. Double options eliminate outguessing market direction.
7. Large market moves provide ample opportunities to make money.
8. Time periods of up to 18 months are available to achieve profit objective.
9. Options permit direct futures trading without margin.
* Trading against an option can enhance potential. Additional funds may be required in certain situations as your Account Executive can explain.
CONTRACT FULFILLMENT
The contractual fulfillment of London Commodity Options, as represented and offered by Options Trading Corporation is protected by the Rules and Bylaws of the appropriate London Exchange. Soft commodities, e.g.: sugar, coffee, cocoa, are registered by the International Commodity Clearing House, Ltd. Metals, e.g.: silver, copper and zinc are registered by the London Metal Exchange.
If you have any questions or need additional information please call us collect.
(B) Representative Commodity Analysis Petitioner
The parties agreed that the 1975-76 London options transaction entered into by Gary Garff (Garff), docket No. 21130-80, was representative of the London options transactions executed by Commodity Analysis. 73
Commodity Analysis initiated Garff’s London options transaction on December 15, 1975, by executing a double option straddle. On that date, Garff purchased a double option for 186 lots of silver (in two separate purchases of 93 lots) for delivery on March 16, 1976, 74 at a premium of 30.2 pence per ounce. The strike prices of the respective options were 202.57 and 200.57 pence per ounce, respectively. A commission of .2 pence per ounce was included in the option premium, 75 thus Garff s account balance at Commodity Analysis was debited £561,720. 76
Garff sold a double option on the same day for 186 lots of silver for delivery on March 15, 1976, 77 at a strike price of 201.5 pence per ounce. The option was sold at a premium of 30 pence per ounce. No commission was charged, thus Commodity Analysis credited £558,000 to Garff’s account. 78
The double option straddle was subsequently closed out 2 days later. On December 17, 1975, Garff offset the bought options by selling identical options for 186 lots of silver (again, in two separate transactions of 93 lots) at a premium of 31.65 and 32.35 pence per ounce, respectively. Commodity Analysis credited £595,200 to Garff’s account for the offsetting sale. 79
Garff then offset the sold double option by purchasing an identical double option at a premium of 32 pence per ounce. Commodity Analysis debited Garff s account in the amount of £595,200 80 for the offsetting purchase. No commissions were charged on either closing transaction. The net result to Garff from closing out the double option straddle was a loss on the sold (granted) option in the amount of £37,200 81 and a gain on the purchased options in the amount of £33,480. 82
Garff converted the £37,200 loss on the sold double option to dollars at a conversion rate of 2.03 dollars/pound and reported an ordinary loss of $75,516 on his 1975 Federal income tax return. The gain on the purchased options was converted to dollars at the same rate, resulting in a short-term capital gain of $67,965.
Concurrently with the execution of the option straddle, Commodity Analysis executed a futures straddle for Garff. On December 15, 1975, Garff purchased 75 lots of silver for delivery on August 16, 1976, at a price of 211.24 pence per ounce. On the same date, he sold 75 lots of silver for delivery on September 6, 1976, at a price of 212.7 pence per ounce. No commissions were charged, and Commodity Analysis thus debited Garff’s account £1,584,300 83 for the purchase, and credited £1,595,250 84 to his account for the sale.
On December 17, 1975, Garth closed out the loss leg (the short position) of the futures straddle by entering into a switch transaction. On that date, Garff purchased 75 lots of silver for delivery on September 6, 1976, at a price of 217.7 pence per ounce (no commission was charged). The total purchase price of £1,632,750 85 was debited to Garff’s account. The sold leg of the straddle put on 2 days earlier was thus entirely offset.
Garff completed the switch by selling 75 lots of silver at a price of 218.6 pence per ounce for delivery on September 20, 1976. Commodity Analysis credited £1,639,500 86 to Garff s account for the sale.
The closing out of the short side of the straddle resulted in a loss of £37,500. 87 Garff converted the loss to dollars (at an exchange rate of 2.03 dollars/pound), and reported a short-term capital loss of $76,125 on his 1975 Federal income tax return. The short-term capital loss on the switch transaction offset the entire $67,965 short-term capital gain incurred by Garff on the purchased options. Thus, for 1975, Garff incurred a net short-term loss of $8,160.
Garff’s futures straddle was closed out the next year on July 2, 1976. On that date, Garff sold 75 lots of silver for delivery on August 16, 1976, at a price of 284 pence per ounce and purchased 75 lots of silver for delivery on September 20, 1976, at a price of 286.36 pence per ounce. No commissions were charged on either transaction, and Commodity Analysis credited £2,130,000 88 to Garff’s account for the sale, and debited £2,147,700 89 to his account for the purchase.
Garff thus incurred a gain of £37,500 90 on closing out the futures straddle. Garff converted the gain to dollars at a rate of 1.8 dollars/pound, and reported a net long-term gain of $67,500 for 1976.
Sometime in 1975, Garff paid Commodity Analysis an initial margin deposit of $7,500 for putting on his London options transaction.
Garff’s 1975-76 London options transaction is summarized as follows:
Year Description Gain Net gain (loss) Commission (loss)
1975 Ordinary loss — granted option (£37,200) - - - (£37,200)
1975 Short-term capital gain-purchased options 37,200 $3,720 33,480
1975 Short-term capital loss-futures trades (37,500) - - - (37,500)
1976 Long-term capital gain-futures trades Totals 37,500 - - - 37,500 3,720 (3,720)
c. Broker/Dealers Employing the Option-Hedge Trading Strategy
i. Rudolf Wolff
(A) In General
Rudolf Wolff was originally formed as a partnership in 1866 in London, England. In 1971, the partners dissolved the partnership and formed Rudolf Wolff as the main operating company. Rudolf Wolff also acts as a holding company for various worldwide subsidiaries. Since its inception, Rudolf Wolff has operated as a broker and merchant in metals and commodities.
During the years at issue, Rudolf Wolff employed approximately 25 people in trading activities and was a ring-dealing member of the LME. In addition, Rudolf Wolff was a member of the London cocoa, coffee, sugar, and rubber exchanges and the New York and Hong Kong commodity exchanges. Francis Holford (Holford) was appointed secretary of Rudolf Wolff in 1971 and subsequently became managing director of the company in 1976. Holford’s duties, however, have never involved the day-to-day operations of Rudolf Wolff’s trading and brokering businesses.
During the years at issue, G.C. Douglas Metals, Ltd. (Douglas), acted as a half-commission agent for Rudolf Wolff. Various Douglas personnel had desks within the offices of Rudolf Wolff, including Dermot Butler (Butler), who began working for Douglas in 1970. Butler was a commodity broker and dealer with extensive experience on the English commodity markets in both options and futures trading.
Although Butler was not employed by Rudolf Wolff, he effectively acted as Rudolf Wolff’s option dealer until the late 1970’s. Thus, Butler traded options not only for Douglas’ clients which he introduced to Rudolf Wolff but also for some of Rudolf Wolff’s own clients. In addition, Butler traded futures contracts as well. All option and futures contracts traded by Butler, whether for a Rudolf Wolff or Douglas client, were entered into on a principal-to-principal basis between the client and Rudolf Wolff.
Butler devised the option-hedge trading strategy for the approximately 16 petitioners who entered into option-hedge London options transactions with Rudolf Wolff during 1975-76. Based on his belief that the silver market would rise in the long run, sometime in 1975 Butler would purchase a long position in silver futures for a petitioner’s account. Concurrently, the long position would be hedged by the sale of an out of the money call option for silver. Shortly thereafter, the granted (sold) option would be closed out at a loss in an offsetting trade, and a futures contract would be sold to form a futures straddle. Subsequently, in 1976, after a series of futures trades, the futures straddle would be closed out at a gain approximately equal to the loss incurred on the sold option.
Because all petitioners engaging in option-hedge transactions with Rudolf Wolff maintained discretionary accounts, Butler was solely responsible for deciding which trades would be executed on their behalf. In implementing the option-hedge transactions, Butler was aware that under American tax law losses on sold (granted) options were treated as ordinary losses, while gains on long forward positions held for 6 months or more were reported as long-term capital gains. Butler thus sought to maximize the tax advantages to petitioners when making trading decisions.
Commission charges for executing trades were negotiated among Rudolf Wolff, Butler (for Douglas), and the client. For Douglas’ clients trading through Rudolf Wolff, commissions were generally charged based on some percentage of the underlying contract value. As a half-commission agent, Douglas would receive a portion of the commissions charged by Rudolf Wolff. 91
During the years at issue, Rudolf Wolff used a computer service to mark customers’ accounts to market on a daily basis. All paperwork for petitioners’ trades was generated by Rudolf Wolff. The paperwork would then be forwarded to the client’s half-commission agent.
Butler sometimes would begin a petitioner’s trades before receipt of that petitioner’s initial margin if Butler believed that the funds would eventually be forwarded. For virtually all petitioners entering into option-hedge transactions, Butler agreed to limit their losses to the amount of initial margin deposited. Butler controlled the losses incurred by carefully monitoring the accounts and placing stop-loss orders.
All Rudolf Wolff trades ordered by Butler were executed at prevailing market prices. In addition, Rudolf Wolff laid off all of the trades executed.
Petitioners who entered into option-hedge transactions were introduced to Butler by finders. The record, however, contains no example of the promotional material sent by finders to petitioners who entered into London options transactions with Rudolf Wolff.
(B) Representative Rudolf Wolff Petitioner
The parties agreed that the London options transaction entered into by Phil Hohnstein (Hohnstein), docket No. 1133-80, was representative of the option-hedge transactions executed by Rudolf Wolff.
Rudolf Wolff initiated Hohnstein’s London options transaction on December 15, 1975, by putting on an option hedge. On that date, Hohnstein purchased a futures contract for 100 lots of silver (1 million troy ounces) for delivery on September 15, 1976, at a price of 212.2 pence per ounce. Rudolf Wolff charged Hohnstein a commission of £2,652.50 for the purchase (.125 percent of the underlying contract value), and thus debited £2,124,652.50 to Hohnstein’s account. 92 On the same day, Hohnstein sold a call option for 100 lots of silver for delivery on January 15, 1976, at a strike price of 201.8 pence per ounce. 93 The option was so±d for a premium of 2 pence per ounce, less a commission of £2,522.50 (.125 percent). Rudolf Wolff thus credited £17,477.50 to Hohnstein’s account. 94
Two days later, on December 17, 1975, Hohnstein closed out the sold option by purchasing an identical offsetting option (100 lots of silver for delivery on January 15, 1976, at a strike price of 201.8 pence per ounce) at a premium of 6.8 pence per ounce. Rudolf Wolff charged no commission on the transaction and thus debited £68,000 to Hohnstein’s account. 95
The following day, December 18, 1975, after having left the bought futures contract in an open position overnight, Hohnstein entered into a futures straddle by selling a futures contract for 100 lots of silver for delivery on March 18, 1976, at a price of 206.9 pence per ounce. Rudolf Wolff charged a commission of £2,586.25 on the transaction (.125 percent) and thus credited £2,066,413.80 to Hohnstein’s account. 96
The closing out of the sold (granted) option resulted in a loss of £50,522.50, after commissions. 97 The loss was converted to dollars at an exchange rate of 2.0235 dollars/pound, 98 and Hohnstein consequently reported an ordinary loss from the granted option in the amount of $102,233 on his 1975 Federal income tax return.
On January 21, 1976, Rudolf Wolff resumed trading for Hohnstein and put on a second silver futures straddle (hereinafter sometimes referred to as the 1976 straddle). 99 On February 17, 1976, the short position of the original silver futures straddle (hereinafter sometimes referred to as the 1975 straddle) was closed out in a switch transaction and replaced with a new short position. Hohnstein incurred a gain of £45,413.75 on the switch transaction, which was reported as a short-term capital gain for 1976.
On March 2, 1976, Rudolf Wolff executed a third futures straddle for Hohnstein composed of a zinc short leg and a lead'long leg. The straddle was closed out 3 days later on March 5, 1976, with Hohnstein incurring a £12,540 short-term capital gain on the long position and a £11,880 short-term capital loss on the short position.
On March 26, 1976, Hohnstein closed out the short position of the 1976 straddle in a switch transaction. Hohnstein incurred a short-term capital loss of £210,437.50 on the switch. The short leg was replaced by the sale of a new silver futures contract.
On May 14, 1976, Hohnstein again closed out the short position of the 1975 straddle by purchasing an identical offsetting futures contract. Hohnstein incurred a £378,585 short-term capital loss on the switch.
On July 15, 1976, Hohnstein closed out the long leg of the 1975 straddle and the short leg of the 1976 straddle, leaving a new straddle composed of the short leg of the 1975 straddle and the long leg of the 1976 straddle. Hohnstein incurred a long-term capital gain of £701,347.50 on the long position and a short-term capital loss of £594,765 on the short position.
On September 2, 1976, Hohnstein closed out both legs of the remaining straddle. He incurred a long-term capital gain of £383,336.25 on the long position and a short-term capital gain of £105,757.50 on the short position.
Overall, Hohnstein incurred a net gain of £52,727.50 on futures trades for his 1975-76 London options transaction. 100 The gain was converted to dollars at an exchange rate of 1.7685 dollars/pound, 101 and Hohnstein consequently reported a long-term capital gain in the amount of $93,248.58 from the futures trades on his 1976 Federal income tax return.
On December 15, 1975, Hohnstein wired an initial margin deposit in the amount of $9,500 to Rudolf Wolff’s bank account in New York. On February 23, 1976, Butler returned $500 of the initial margin to Hohnstein. At the conclusion of Hohnstein’s 1975-76 London options transaction, $16 of net equity 102 remained in his account. 103
Hohnstein’s 1975-76 London options transaction is summarized as follows:
Gain-floss) Net gain Commissions (loss) Year Description
1975 Ordinary loss-granted option (£48,000) £2,522.50 (£50,522.50)
1976 Long-term capital gain— 72.900 20,172.50 52,727.50 futures trades
24.900 22,695.00 2,205.00 Totals
ii. Rothmetal
(A) In General
Rothmetal was incorporated under the laws of Bermuda on September 19, 1975, under the name of Thebes, Ltd. On October 14, 1975, the corporate name was changed to Rothmetal. During the years at issue, Rothmetal was not a ring-dealing member of the LME.
Sometime in the fall of 1975, Anderson, the managing director of Commodity Analysis, introduced Philip Greenberg (Greenberg) to Michael Collins (Collins), the managing director of Rothmetal. Greenberg had engaged in the trading of physical commodities, futures, and options during the prior 15 to 20 years. Although Greenberg primarily dealt in coffee and sugar, he also had traded silver, copper, lead, zinc, and copper wirebars on the LME.
Greenberg subsequently became an advisor to Rothmetal in late 1975. Greenberg’s duties included supervising finders who introduced business to Rothmetal, reviewing various transactional documents, and ensuring that initial margin deposits were sent. For his services, Rothmetal paid Greenberg 15 percent of the gross commissions earned on business he introduced to Rothmetal.
Greenberg also actively participated in the creation of the option-hedge trading strategy employed by Rothmetal during 1975 through 1978. For the approximately 82 petitioners who entered an option-hedge London options transaction with Rothmetal, two straddles consisting of a long futures position hedged by the sale of a call option and a short futures position hedged by the sale of a put option would be executed in the first year of the transaction. Shortly thereafter, both options would be closed out in offsetting trades and replaced by futures contracts to form two futures straddles with the open futures positions. Overall, the closing of the option positions resulted in a net loss in the first year of the transaction. Subsequently, in the next year, the futures straddles would be closed out for a net gain approximately equal to the net loss incurred on the sold options.
All London options transactions were executed by Rothmetal on a discretionary basis. In addition, all trades were executed between Rothmetal and petitioners on a principal-to-principal basis. Commissions for trades were negotiable and depended upon a variety of factors. Commissions were listed as clearing charges on petitioners’ final statements of account. Rothmetal laid off all trades with Commodity Analysis.
The following promotional material was distributed by finders to petitioners who engaged in London options transactions with Rothmetal:
COMMODITY TRADING STRATEGY
The Commodity Trading Strategy set forth on the attached flow chart (“Commodity Trading Strategy”) is a complex financial transaction suitable only for persons having both substantial financial experience and substantial income subject to federal income taxes at a marginal rate of not less than 50%. In addition, the Commodity Trading Strategy involves substantial risk factors. The following statement of risk factors and the attached flow chart are not intended to be a substitute for a detailed individual review by competent financial, tax and legal advisors taking into account the individual circumstances of each prospective client. EACH PROSPECTIVE CLIENT MUST MAKE AN INDEPENDENT JUDGMENT AS TO THE POTENTIAL BENEFITS AND RISKS OF THE COMMODITY TRADING STRATEGY. NO PERSON HAS BEEN AUTHORIZED BY ROTHMETAL TRADING LTD. OR ITS ASSOCIATES TO MAKE ANY OTHER REPRESENTATIONS OR WARRANTIES AS TO THE POTENTIAL BENEFITS AND RISKS OF THE COMMODITY TRADING STRATEGY.
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IMPORTANT RISK FACTORS
1. Tax Consequences
The Commodity Trading Strategy is predicated upon certain interpretations of the existing provisions of the Internal Revenue Code and the regulations promulgated pursuant thereto. No ruling from the Internal Revenue Service has been obtained by Rothmetal as to the tax consequences of the Commodity Trading Strategy and Rothmetal does not presently intend to apply for such a ruling. CONGRESS IS PRESENTLY CONSIDERING CHANGES IN THE TAX LAWS WHICH, IF AND WHEN ENACTED, COULD EFFECTIVELY ELIMINATE THE TAX BENEFITS OF THE COMMODITY TRADING STRATEGY. The tax consequences of the Commodity Trading Strategy may not be the same for all taxpayers. Accordingly, prospective clients must consult with their tax advisors with specific reference to their own tax situation under Federal tax law and the provisions of applicable state tax laws.
2. Margin Transactions
All of the transactions contemplated by the Commodity Trading Strategy will be made as margin transactions. Because of the low margin deposits normally required in commodity futures trading an extremely high degree of leverage is typical of a commodity futures trading account. As a result, a relatively small movement in the prices of silver futures contracts and options will have a substantially greater effect on a client using the Commodity Trading Strategy. To the extent that the Commodity Trading Strategy involves, “hedged” transactions, the risk of market fluctuation is reduced and lower margin deposits and fees are required. Generally, the fees charged as a result of transactions under the Commodity Trading Strategy will not exceed an amount equal to the initial margin deposit made at the time of commencing the Commodity Trading Strategy transactions.
3. Market Fluctuations
The Commodity Trading Strategy is intended to minimize the risks of fluctuations in the market price of silver futures contracts and options. However, the Commodity Trading Strategy is predicated upon the assumption that “spreads” between the prices for futures silver contracts in adjacent months will remain relatively constant. To the extent that the “spread” between the prices in adjacent months varies, the Commodity Trading Strategy may result in additional gain or loss.
4. Other Transactions
During the course of the Commodity Trading Strategy, a client may wish to engage in other transactions involving the open positions created as a result of the Commodity Trading Strategy. To the extent that such transactions are engaged in, additional margin deposits, fees and market risks are entailed.
* * * * * * *
Each prospective client is requested to date this statement of risk factors and verify that such client has not received and is not relying upon any other representations or warranties concerning the Commodity Trading Strategy. Therefore, PLEASE WRITE THE FOLLOWING SENTENCE IN YOUR OWN HANDWRITING:
“Except as set forth above, I have not received nor am I relying upon any representations or warranties concerning the potential risks or benefits of the Commodity Trading Strategy.”
Dated:_ _
TAX SPREADS
Our Trading Strategy turns ordinary income into long-term capital gains by using a unique application of the traditional commodity tax spread or straddle. Therefore, it would be appropriate to elaborate on the mechanics of spreads. In past years, the traditional tax spread has been used only to defer capital gains taxes from year to year or to convert short-term capital gains into long-term capital gains.
When done properly, this method of investment minimizes the risks inherent in the market place because the tax-spreader always takes both sides of the market at the same time. That is, he simultaneously buys a long position (betting on the commodity investment to go up) and sells a short position (betting on the same commodity to go down). It is easily seen that it doesn’t matter whether the commodity goes up or down, since always one side of the spread gains money while the other side loses an equivalent amount of money. The tax spread takes advantage of this by liquidating the loss side of the spread in the present tax year while holding and hedging the equivalent unrealized gain until the succeeding tax year. This allows the taxpayer to deduct these losses against gains in the present year and thus defer the taxes until the following year. Everything discussed so far is common knowledge and has been used successfully for many years, but only in the area of capital gains.
Our Trading Strategy is especially unique because of its ability to create ordinary losses in markets that heretofore only allowed for capital gains or losses. Recently the IRS ruled that any income or loss resulting from “closing transactions” from sales of put and call options to be classified as ordinary income or loss (see enclosed IRS letters and rulings). Our Trading Strategy always engages the sale or “writing” of put and call options where these transactions are liquidated by “buying back” the options in the future (closing transactions) and thus resulting in net ordinary losses.
Our strategy constructs spreads where one side of the spread is a set of silver futures contracts bought or sold for net capital gains while on the other side are equivalent put or call option sales against the underlying silver contracts for net ordinary losses (see enclosed flow chart). It is the combination of IRS rulings that permits organization of a series of these spread transactions which effectively convert ordinary income to long-term capital gains. For details on the mechanics of these transactions see enclosed example. As can be seen in the example, we create ordinary losses by selling put or call options at a lower price today than we buy them back for in the future. Whatever ordinary losses occur in these spreads, we automatically have equivalent capital gains since we are always hedged (i.e. on both sides of the market). Options are ideal with these transactions because of the limited down side movement in option premiums against an unlimited upside resulting in limited ordinary gains and unlimited ordinary losses (which are hedged) giving us exactly what we want in this type of tax spread.
It would be appropriate here to define an option. A “call” is an option to buy property such as real estate, securities or commodity future contracts. A “put” is the opposite, an option to sell. The most common example of a call option is the real estate option to buy property. All options contracts include, a span of time for which the offer is held open, an offering price for the property itself (called the striking price) and a cost for buying the option (called the option premium). For example, if you owned a piece of real estate, you could write an option against the underlying property for say, $100,000 that is good for the next six months. Anyone desiring to tie up this property at $100,000 offering price for six months would buy this option from you for say $1,000 (the option premium).
One of three things can then happen to the option (a) The option is exercised if the option holder buys the property within six months for $100,000 (b) The option is not exercised within the six months and expires (c) Prior to the six month expiration, the option is sold to another party. In our transactions for taxes (a) and (b) never occur since the “sold” options are always bought back in a closing transaction prior to expiration or exercise.
The preceding example can similarly be applied in the securities and commodities markets. We have chosen the commodities markets on the London Bullion Markets for tax transactions because of the following reasons (a) Real estate does not work because of little liquidity, little market movement and no real “put” options available (b) The stock market options in the U.S. are not feasible because of no “put” options available, large fluctuations in spreads resulting in high risk, too little leverage available (i.e. it’s ridiculous to buy $2,000,000 of IBM stock to create a $100,000 loss) and commission costs are exorbitantly high, (c) The U.S. commodities markets do not have puts and calls available which are what the IRS rulings are based on.
The only alternate is to use the largest foreign market exchange in the world, the London Bullion Market, because all the tools that are needed are available at minimum risk. Here the tax client is insured that all transactions made are registered (cleared) trades through the Bullion Market with detailed records checked monthly by the Bank of England. He is also quoted a firm but low price for effecting these trades (no more than 15%) [sic] of the amount to be converted).
OCT. 23, 1975
(A) Buy (Long) 23, June ’76 Futures Contracts @ 222.70 [pence]
(B) Sell (Write) 23, Jan ’76 Call Options against underlying silver from (A) @ 215.40 [pence] strike price & 20 [pence] Premium. Client’s Acct. is credited with 680,000 X 20 [pence] = [£]136,000
(C) Sell (Short) 23, July ’76 Futures Contracts @ 229.40 [pence]
(D) Sell (Write) 23, Feb ’76 Put Options against underlying silver from (C) @ 213.80 [pence] strike price & 27 [pence] Premium. Client’s Acct. is credited with 680,000 X 27 [pence] = [£] 183,600
OCT. 28, 1975 (Silver went down)
(E) Sell (Short) 28, June ’76 Futures @ 220.30 [pence] to hedge in loss from (A) of 2.4 [pence] X 680,000 = [£]16,320
(G) Buy (Long) 28, July ’76 Futures @ 220.35 [pence] to hedge in gain from (C) of 9.05 [pence] X 680,000 = [£] 61,540
(F) Closing transaction of Calls from (B) by buying back @ 17.70 [pence] X 680,000 = [£]120,360 debit vs. [£] 136,000 credit (B) giving a gain of [£] 15,640
(H) Closing transaction of Puts from (D) by buying back @ 35.95 [pence] X 680,000=[£]244,460 debit vs. [£] 183,600 credit (D) giving a loss of [£] 60,860
Net hedged-in capital gain from transactions (E) & (G) are 61,540 - 16,320 = [£] 45,220 (or US $93,442) less clearing charges. These hedged-in capital gains are held for at least 6 months for long-term gains.
Net realized losses from options closing transactions (F) & (H) are 60,860 - 15,640 = [£] 45,220 (or US $93,442) plus clearing charges of [£] 3,630 (or US $7,501) for a total of $100,943 in losses.
Note: You are advised to check with your tax counsel on present IRS rulings regarding the treatment of options closing transaction losses.
(B) Representative Rothmetal Petitioner
The parties agreed that the 1975-76 London options transaction entered into by Robert A. Meese (Meese), docket No. 12009-80, was representative of the option-hedge transactions executed by Rothmetal.
Rothmetal initiated Meese’s London options transaction on October 9, 1975, by putting on two option-hedge straddles. On that date, Meese sold a call option for 102 lots of silver for delivery 104 on January 9, 1976, at a strike price of 216.4 pence per ounce. The option was sold for a premium of 21 pence per ounce, thus Rothmetal credited £214,200 to Meese’s account. 105 The call option was hedged by the purchase of a futures contract for 102 lots of silver for delivery on September 9, 1976. Rothmetal sold the futures contract to Meese at a price of 234.65 pence per ounce, and debited his account £2,393,430. 106
The second straddle was executed by Meese’s selling a put option for a premium of 14 pence per ounce for 102 lots of silver for delivery on December 9, 1975, at a strike price of 212.15 pence per ounce. The put option was hedged by the sale of a futures contract for 102 lots of silver for delivery on October 8, 1976, at a price of 238.05 pence per ounce. Rothmetal credited £142,800 107 and £2,428,110, 108 respectively, to Meese’s account for the sale of the put option and futures contract.
The option positions were subsequently closed out 4 days later. The sold call option was offset by the purchase of an identical call option (102 lots of silver for delivery on January 9, 1976, at a strike price of 216.4 pence per ounce) at a premium of 20 pence per ounce, plus a commission charge of £1,428. The sold put option was similarly offset by the purchase of an identical option 102 lots of silver for delivery on December 9, 1975, at a strike price of 212.15 pence per ounce) at a premium of 17.1 pence per ounce, plus a commission of £1,428. Rothmetal debited £205,428 109 to Meese’s account for the purchase of the call option and £175,848 110 for the purchase of the put option.
The call option leg of the straddle was replaced by the sale of a futures contract for 102 lots of silver for delivery on September 13, 1976, at a price of 234.65 pence per ounce. The put option leg of the second straddle was replaced by the purchase of a futures contract for 102 lots of silver for delivery on October 13, 1976, at a price of 235.95 pence per ounce. Rothmetal credited £2,393,43o 111 to Meese’s account for the sale and debited £2,406,690 112 to his account for the purchase.
As a result of closing out the sold options, Meese incurred a gain of £8,772 113 on the call option and a loss of £33,048 114 on the put option, after commissions. Thus, he incurred an overall net loss on sold options of £24,276 (£8,772 gain less £33,048 loss) for 1975. Meese reported an ordinary loss of $50,000 from the sold options on his 1975 Federal income tax return.
Rothmetal resumed trading for Meese on May 13, 1976. On that date, Meese purchased a futures contract for 15 lots of silver for delivery on August 13, 1976, at a price of 255.75 pence per ounce. The open position was closed out the following day by Meese’s selling an identical offsetting contract at a price of 253.4 pence per ounce, less a co

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4512421. Public record. Not legal advice.