Australian Capital Gains Tax creates a situation where it is not optimal for an Australian Investor to carry an open short option position over the change in financial year, regardless whether there is an unrealized capital gain or loss from the option transaction. Theoretically in perfect markets, a rational investor who wrote an option should close out their position at the end of the year and re-establish them. at the start of the following financial year. Investors wanting to write new options near the end of the financial year should wait until the following financial year to do so. This paper examines the cause of these tax-induced distortions and then looks to see if the market does in fact react to this tax effect.
In detecting this end of financial year tax motivated behaviour in the Australian options market, this thesis examines the levels of open interest in the Australian Stock Exchange over the change in financial year. When investors collectively close their open option positions at the end of the financial year, there would be an expected decrease in the level of the open interest. When they re-establish their positions and write new options in the following financial year, there would be an expected increase in the level of open interest.
The results show that level of open interest is higher at the start of the new financial year, mostly due to an increase in the level of open interest in the new financial year. However, the results show that investors are closing their open positions at the end of the financial year when the option is deep in the money and the tax benefits are maximised. The option writers are closing out their positions more than one month before the end of the financial year and re-establishing it more than one month after the start of the following financial year. There is also evidence of individual investors choosing to write options for some of the largest firms and not for others.
Overall the statistical evidence does indicate that option writers are planning and managing the taxation of their investments in order to maximize returns.