Years ago when I was an options market maker on the CBOE, many of the traders had very bad trading results tax-wise during Decembers. In those days, the positions of market makers were not marked to market as they are now. So they held on to their unliquidated gains and liquidated their losses. However, in order to roll millions of dollars of income from one year to the next, they did certain types of trades in the options of highly volatile stocks, which were designed to create large unliquidated gains and large liquidated losses before the end of the year. This strategy worked very well, as market makers reported very little income until the rules were changed in the early 1980s. The market makers ever since have to report the marked to market values on the last day of the year as income.
But these rules only applied to market makers and not to the public, as the public was still able to do hedging strategies with stock and/or listed options whereby it could create artificial capital losses. For example: buying a large number of calls and simultaneously selling a large number of closely related calls on the same stock, and create what is called a "spread." The idea is to wait for the stock price to change substantially and then liquidate the losses and roll into another offsetting position, while maintaining the long position in the calls with the unliquidated gains. (For a comprehensive overview of options, refer to our Options Basics Tutorial.)
Again the rules were changed to disallow that tax strategy, and title 26, Ssection 1092 was passed by congress to prevent the artificial creation of temporary capital losses by the public.
In later years, Section 1092 was modified to allow the "identified straddle" to be recognized to not discriminate against legitimate hedging.
How does Section 1092 affect traders and investors today? Essentially, it says that if you have positions in stocks or options that are offsetting each other, then they are subject to Section 1092. It says that losses on one of those positions when liquidated are reportable currently only to the extent that they exceed the "unrecognized gain" of the offsetting positions. It also says that if the positions are "identified straddles," the liquidated losses can be used to increase the cost basis of the identified offsetting positions.
Offsetting positions regarding traded stock and options are considered to be ones that substantially reduce the risk of holding the other position. For example, holding stock that is trading at $30 and selling calls that have an exercise price of $20 creates an offsetting position and is subject to Section 1092.
Assume that the stock goes to $40 and there is a $9 loss on the calls that you are short. If the loss is liquidated, it is not reportable currently until the offsetting position in stock is liquidated or if the offsetting "unrecognized gain" at the end of the year is less than the loss of $9. If the "unrecognized gain" is just $3 because the stock is trading at $33 at the end of the year, then $6 of the liquidated loss is reportable currently.
If you had designated the offsetting positions as an "identified straddle," then the $9 loss would increase the basis of the stock by $9, making it such that if the stock was sold at $45, the gain on the stock would be reduced for tax purposes by $9.
Buying puts that are at-the-money or in-the-money versus long stock will also expose the investor to section 1092. However, buying puts that are substantially out-of-the-money probably will not subject the trader to the Section 1092 because the purchase of the out-of-the-money puts do not substantially reduce the risks of holding the stock. In fact, the substantially out-of-the-money puts may add more risks than they reduce.
The "Qualified Covered Call Exemption"
If the owner of the stock sold calls that were considered "qualified covered calls," these calls and the stock would not be subject to Section 1092.
"Qualified covered calls" have a very technical definition which essentially says the following: If you own 1,000 shares of stock and sell 10 calls that are not in-the-money (that is if the calls are at-the-money or are out-of-the- money) with more than 30 days and less than 33 months to expiration, those calls do not create a Section 1092 straddle. In this case, the long stock versus short calls are treated as separate positions for tax purposes. The gains and losses are capital gains and losses. (For more on capital gains, see Tax Effects On Capital Gains.)
Time Premium Sellers
Now suppose you were interested in selling "time premium" in a stock like Apple Computers, and decide to sell January 10, 2011 calls and January 10, 2011 puts with a strike price of 190 with the stock trading at 185. Assume you were able to get a total of $66,000 for the total sales. Those two positions would be considered offsetting for section 1092 unless you also owned 1,000 shares of Apple stock (which we assume here that you do not).
Now let's assume that six months later Apple was trading at 130. In this case the calls are lower and the puts are higher. If you were to buy back the puts at a $15,000 loss, the liquidated loss is reportable currently only to the extent that it was greater than the "unrecognized gain" on the calls that you sold. If the calls were bought back giving an $11,000 gain, the $15,000 loss from the sale and repurchase of the puts will raise the cost basis of the calls by $15,000. Thus the net loss is $4,000, and is reportable currently.
Conclusion: Related Persons
Section 1092 also applies to offsetting positions that are done by related persons. For example, if you were to sell puts in an IRA and sell calls in your personal trading account as in the above case with Apple, the offsetting positions would be considered subject to Section 1092 and create some very interesting tax opportunities. If a person owns stock in his personal name, he will also be considered to have a Section 1092 straddle if his wife buys puts in her IRA.