As another example, the S&P 500 e-mini contracts have a multiplier of 50, which just means the total contract value is 50 times the level of the S&P 500. If the index is say 1,100 then the total value you’re controlling with one futures contract is 1,100 * 50 = 55,000. The tax would be $55,000 * .0002 = $11 per contract to buy and sell.
Option contracts will also be affected. And just like the futures contracts, the 2-basis point tax will be levied on the total contract value – not the total dollars spent on the options. For example, assume Google is trading for $600 even. If you buy 10 call options for $3,000, your tax is not based on the $3,000 spent. It is based on the $600 stock price multiplied by the 1,000 shares you’re controlling. The tax would therefore be $600,000 * .0002 = $120.
It’s a little unclear at this time whether they will use the underlying price at the time of purchase as the base or whether they will use the strike price multiplied by the number of shares. If they use the strike price, it will have serious effects as it will be more costly to buy OTM call options but cheaper to buy OTM put options.
For this reason, my guess is that they will have to tie the tax to the value of the underlying at the time the option contracts were purchased or sold. Of course, that means that brokerage firms must tweak their software to take a snapshot of the stock price at the time you trade the contracts in order to calculate the tax.
The proposed two-basis point tax will also apply to other derivatives such as swaps and credit-default swaps, which are typically only used by banks and other institutions so there’s really no need to talk about them here.
Apparently, the tax serves a two-fold purpose. First, it is intended to deter high volume speculators. Second, it is estimated the tax will raise $150 billion a year that the government can use to "invest in our future, our infrastructure and our middle class.'' According to DeFazio, half of the money raised by the tax would go to reduce the deficit while the remainder would be used finance jobs.
At a recent news conference, DeFazio stated, ''The American taxpayers bailed out Wall Street during a crisis brought on by reckless speculation in the financial markets. This legislation will force Wall Street to do their part and put people displaced by that crisis back to work. Main Street bailed out Wall Street so it's time for Wall Street to return the favor.'' Senator Harkin added, ''There is no question that Wall Street can easily bear this tax.''
While DeFazio has many supporters, he has many opposed to the idea – even within his own party. Further, and more importantly, the Obama administration is opposed to the idea as are all of Wall Street’s influential banks and investment houses. So despite the fear that many of you have expressed in emails, prospects for the bill are probably not good.
One of the criticisms is that the imposition of such a tax would place a burden on an already fragile economy. As the cost of trading increases, people will do less, which have rippling effects through the brokerage firms and the economy. There is a very good chance it could drive up the already high unemployment rate of 10.2%. Further, critics argue the tax may have serious unintended consequences on our financial markets by raising the cost of credit and private investment for businesses and governments alike.
DeFazio rejected those suggestions, citing that the U.S. imposed a transaction tax between 1914 and 1966. In fact, the tax was doubled during the Great Depression yet the stock market and the economy thrived. In addition, Great Britain currently levies a transaction tax that his higher than the one he proposes yet no one has fled their stock market. DeFazio also offered the support of British Prime Minister Gordon Brown, who recently called for a global transaction tax.
Despite the potential pros and cons, here’s another problem that will affect everyone – even if you’re not trading more than $100,000 worth of stock during the year. The tax will decrease the opportunities for speculators, driving many out of the market. You can be sure that the small windows of opportunities that existed for those traders will be virtually eliminated by the tax. And if you recall at the beginning of this podcast, driving out the speculators is one of their goals.
I’m not so sure that getting rid of the speculators is a good thing for the overall market. Speculators provide an important economic function in that they provide liquidity to the market. Regardless of the time frame speculators may wish to hold shares, their desire to trade ensures we have more buyers and sellers present. That means smaller bid-ask spreads.
If sufficiently high numbers of speculators are driven out, you will see bid-ask spreads widen, which imposes a very big cost on everyone, not just those trading more than $100,000 worth of stock through the year. All buyers pay more; all sellers receive less. That money must be accounted for when assessing the benefits of the tax. Yes, the tax will undoubtedly raise new revenues. But if the costs to obtain those revenues are greater, the tax creates an overall loss. Getting rid of speculators may therefore cost more than the taxes raised by the bill.
For similar reasons, option bid-ask spreads will be affected. Many traders who once, for example, bought put options for insurance may elect to go without. Traders who once sold call options as a way to hedge some of the downside risk may find it’s no longer worthwhile. The tax is therefore imposing risks that many traders ordinarily would not have accepted. Those social costs must be accounted for too in assessing the true value of the tax.
Supporters claim the tax will raise about $150 billion dollars. Half of that will be deposited in a Job Creation Reserve to fund the creation of good paying jobs and put Americans back to work rebuilding our nation’s infrastructure. The second half of the revenue generated by this transaction tax (approximately $75 billion) would be used to directly reduce the deficit.
While those sound like great reasons for supporting the tax, I have never seen a tax directly applied to the deficit with any success. It’s a politically appealing motive that gains votes but the bottom line is that it is the spending in Washington that must be controlled. New taxes just open the doors for more spending.
As Nobel Prize winning economist Milton Friedman once said, “If you put the federal government in charge of the Sahara Desert, in five years there’d be a shortage of sand.”
If the bill passes, I doubt very seriously you’ll see any reduction in the deficit. And that will only be one more reason for them to raise taxes again.
Options trading and investing can be very rewarding but you must understand all of the fundamentals in order to master the art and science of options trading. For those who would like to advance their knowledge, you may wish to consider the Alpha Trader Certificate Course and Strategy Lab.
Knowledge is a risk-free investment and understanding the proposed Harkin-DeFazio tax bill can only make you better at the art and science of options trading.