Taxation of Options

An investor who purchases a call or put that expires worthless will have a short-term capital loss. An investor who purchases long-term LEAPS (Long Term Equity Anticipation Securities), which have a term of up to 39 months that eventually expire, will have a long-term capital loss. The writer of both LEAPS and traditional options that expire worthless will have a short-term capital gain.

Example:

An investor buys 10 FGH May 40 calls at 1. If at expiration, FGH is a 37 and the investor

allows the calls to expire, the investor will have a $1,000 loss. Alternatively if the investor who sold the 10 FGH May 40 calls at 1 allows the calls to expire, the investor will have a $1,000 capital gain.

Closing an Option Position

Executing an order to close an option position will result in a capital gain or capital loss if the closing price differs from the opening price.

Example:

An investor buys 5 TRY August 40 calls at 4. If TRY increases in price to 47 and the investor sells the calls at 9, the investor will have a $2,500 capital gain. The investor paid

4 for the calls and sold them at 9 resulting in a $5 per share profit on 500 shares. Alternatively, if TRY fell to 41 and the investor closes out the position by selling the

calls at 1, the investor would have a $1,500 capital loss. The investor would have lost $3 per share on 500 shares.

An investor who sells 2 ABC July 60 puts at 7 and covers the position with a closing purchase by buying back the puts at 2 will have a $1,000 capital gain. The investor made

$5 per share on 200 shares. Alternatively, if ABC fell in price and the investor covered the short puts with a closing purchase by buying back the puts at 11, the investor would

have an $800 loss. The investor lost $4 per share on 200 shares.

Exercising a Call

If an investor exercises a call option, the option’s premium is added to the investor’s cost base for the stock to determine any capital gain or capital loss. For tax purposes, the holding period for the stock begins when the call is exercised. If an investor wrote a call, the call option’s premium must be added to the option’s strike price to determine the investor’s proceeds on the sale of the stock if the stock is called away.

Example:

An investor buys 1 JKL September 60 call at 3 on Tuesday July 7th. If on Monday August

2nd, JKL is trading at 68 and the investor exercises the call, the investor’s holding period would begin on August 2nd not on July 7th when the investor purchased the call. The

investor’s cost base for JKL after exercising the call is 63, the call’s strike price plus the

premium.

 

An investor who sells 1 RTG May 40 call at 5 and has the stock called away from them will have an effective sale price for RTG of $45. Investors who sell calls and have the stock called away must add the call option’s premium to the strike price to determine the sale proceeds for tax purposes.

Exercising a Put

An investor who exercises a put must subtract the put’s premium from the option’s strike price to determine their proceeds from the sale. A put writer who is exercising a put must subtract the premium from the strike price to determine their cost base for the stock. An investor who is short a put and who is assigned the stock will subtract the premium received from the strike price to determine their cost base for tax purposes.

Example:

An investor purchases 1 CVB October 70 put at 3. If CVB falls to 60 and the investor purchases the stock and exercises the put, the investor will have a $700 capital gain. The investor purchased the stock at 60 and subtracts the premium paid for the put from the strike price to determine the sale proceeds. In this case 70 – 3 = 67.

An investor who sells 1 KLM November 80 put at 9 and who is assigned the stock will have a cost base for the stock of 71.

Protective Puts

An investor who has purchased a protective put on a stock held less than 12 months will cap the holding period for that stock at 12 months and will have a short term gain or loss on the sale of the stock. If the stock was held for more than 12 months before purchasing the put, any gain or loss will be long term. Married puts purchased on the same day as the stock will not automatically create a short-term gain or loss for the stock so long as the puts are identified as a hedge or as married puts when the order is executed. If the put expires, the put’s premium is added to the stock’s cost base.

Covered Calls

An investor who sells out of the money calls will not change their holding period for the stock if the calls expire. An investor who sells deep in the money calls on a stock held less than 12 month will have a short term gain or loss.

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