Last week, I promised to follow up on an article comparing the VIX and VXN, but this week, something that's perhaps more important to options traders has resurfaced: a potential tax on transactions.

Back in February, I posed the question "What Could Go Wrong?" with our style of trading in a February 20, 2009 Trader's Corner article. Back then, one of the threats to the way we trade was a proposal by Congressman Peter DeFazio, H.R. 1068.

Billed then as the "Let Wall Street Pay for Wall Street's Bailout Act of 2009," the bill sought to impose a 0.25 percent tax on transactions on "certain securities," including options and futures. That article included this link to follow H.R. 1068's progress or lack of progress. In the subsequent months, I've frequently checked the status of H.R. 1068, but it has yet to have made it out of committee after it was referred on February 13, 2009 to the House Committee on Ways and Means.

Imagine my surprise then, when Jim Brown mentioned this week that talk of the transaction tax had resurfaced, with the tax perhaps to be attached to a jobs bill. By now, Jim Brown may also have addressed the issue in his Wrap, but I wanted to present the information here, too, as its impact on active options traders could be deleterious.

If you've been reading my articles for any length of time, you've occasionally heard me discuss "risk of ruin," a term borrowed from gamblers calculating their risk of wiping out their funds. One truism about such calculations for stock and options traders is that, the higher the fees associated with each trade, the higher the risk of ruin. Letting losses grow too big and cutting winning trades off too soon also increase the risk of ruin.

Obviously, a transaction tax would increase the risk of ruin for options, stock and future traders. We don't know how severely because the talk circulating is far from specific about how such a tax would be imposed. In a November 18 Reuters article titled "US financial trade tax faces uphill battle," writers Kim Dixon, Andy Sullivan and Thomas Ferraro mention that current ideas include a 0.25 percent tax on stock transactions, a 0.02 percent tax on futures, swaps and credit default swaps, and an option tax that is the same as that of the underlying. I presume that means that if your options have an equity underlying, you would pay the 0.25 percent tax. This article mentions that the first $100,000 of trades each year would be exempted.

However, in a November 19 Bloomberg article, "Hoyers Says Financial-Transaction Tax 'On the Table' in Congress," writers James Rowley and Ryan Donmoyer characterize the proposed tax as being applied to "transactions of more than $100,000, according to a letter sent to House colleagues" the day before the article appeared. While few of us reading this article routinely complete single transactions of more than $100,000, a lot of us who trade actively complete transactions of more than $100,000 a year, and sometimes much more. For example, on November 20, I opened a 30-contract RUT iron condor, with the four legs of that trade including selling 30 calls, buying 30 calls, selling 30 puts and buying 30 puts. Although I entered the order as a single iron-condor order, my activity page shows four separate lines of transactions with credits and costs of ($10,485.12), $12,344.88, ($5,445.12), and $7,604.88. This is just one of my iron condors for January, and January is just one of the 12 months a year that I trade. You can see that my trades would meet that $100,000 threshold rather quickly.

Or would they? This order was entered a single order, and the resultant credit I took in, as can easily be calculated, was $4,019.52. So would I pay that transaction tax on only $4,019.52 or on each of my trades? Would only $4,019.52 go toward meeting my $100,000 threshold per year, if that's the way an eventual bill might be set up if passed? Or, would each of those trades listed in a separate line on my activity page go into that $100,000 calculation?

Furthermore, while the Reuters article speculates that the first $100,000 of trades each year would be exempted, the Bloomberg one characterizes the letter sent out by Representatives DeFazio of Oregon, Arcuri of New York, Perlmutter of Colorado, Braley of Iowa, Sutton of Ohio, Filner of California, and Perriello of Virginia somewhat differently. In the Bloomberg article, the authors report that the letter proposes that the "tax would be refunded for transactions less than $100,000" (my emphasis). This again brings up the risk-of-ruin concern. If each line on my activity page is considered a single transaction that would be taxed, and then that tax would eventually be refunded--Maybe when I file my income tax?--my risk of ruin rises.

I should add a note here. When I reference that risk-of-ruin term, I don't mean the term to be alarmist. A 0.25 percent tax on $4,019.52 isn't going to run my account into the ground, and likely a 0.25 percent tax on each single option trade that makes up an iron condor wouldn't, either. This is a term meant to measure when risks go up, and that's how I'm using it here. Adding a transaction tax does work toward making my losses bigger and my winners smaller, thereby increasing that risk to some degree, but it may be even more deleterious for those with smaller trading accounts, when commissions and fees already eat up a much larger percentage of each trade's possible profit.

The Bloomberg article also mentions that refunds would be given to those "involving assets kept in individual retirement accounts, education savings accounts and health savings accounts." Ditto the problem, however. If those taxes are refunded immediately, that's not such a problem, but if at the end of the year, that's a problem.

A Google search of "0.25 transaction tax" turns up several articles with titles including such words as "unintended consequences." We all saw the unintended consequences last year when the SEC temporarily banned short selling in financials and removed the exemption that market makers have, so that they had no way to hedge the risk they were taking on to keep markets liquid. I have heard market makers recount tales of the losses that they experienced the day that decision was made public, before action by those involved in the CBOE and other such groups convinced the SEC to exclude the market makers again. Those seeking an easy way to punish Wall Street may not be thinking of an unintended consequence: punishing Main Street.

As the title of the Reuters article makes clear, many doubt that such a tax enjoys widespread support. The article speculated that the Senate would not be likely to back such a tax. U.S. Treasury Secretary Timothy Geithner reportedly does not like the idea, and the article quotes Anne Mathias, a Washington analyst, as saying that the Obama administration does not support such a tax, either. Other opposition is mentioned, but the Bloomberg article makes it clear that it's one of the many ideas still being kicked around as a way to pay for jobs-creation legislation.

I've used examples from my own trading, not because I'm unduly alarmed or because my particular way of trading must be protected at all costs. However, I worry about anything that decreases liquidity in the stock and options markets, as such measures also reduce my ability to buy a stock and then protect my purchase by the insurance that puts or collars provide. I've just spent about an hour convincing a friend of the benefits of collaring a stock position that he's unwilling to sell, so I do believe in using options in this manner. I'm old enough to remember trading with a traditional broker, a traditional broker who was old enough to tell me tales of having to call around and search for someone who would sell a put or call that his client wanted to buy and then having to negotiate a price, a process that could take a while.

My first thought was that some people would be pulling money out of their brokerages if the tax is passed and is onerous enough to cause problems for those who count on many small profits in their trades. But maybe I'm thinking of it wrong. If the tax is on the amount of the transaction, perhaps derivatives will see a resurgence. It's a lot cheaper to buy 10 calls on a desired underlying and pay the transaction tax on that than it would be to buy 1,000 shares and pay the transaction tax on that larger amount. We just don't know all those unintended consequences.

At this moment, I'm not fearful about this tax being passed, but I am watchful. I plan to do some thinking about how my trading would change if such a tax were passed, doing the kind of just-in-case planning that helps me sleep at night. I plan to write my Representatives and Senators and present my concerns. If you want to do the same, you can find the contact information for your senators here and the contact information for members of the House of Representatives here. I'm not telling you what to say. Perhaps you agree with the tax; perhaps you disagree.

Next week, I'll deliver the promised article second article on the VIX and VXN, already roughed out and ready for publication.