Ok, by popular demand, I’m going to attempt to explain what are puts, calls, and straddles and the tax implications of each. First, get the kids away from the TV and, please, don’t try this at home!
The following is gleaned from The Tax Book, Deluxe Edition, P. 6-11. “A call option is the right to buy from the writer of the option, at any time before a specified future date, a stated number of shares of stock at a specified price.” Generally speaking, the holder or buyer is expecting an increase in the value of the stock and most probably will exercise the option if the value increases. Think of the phrase, “call up”. This is what you will see if we are in a “bull” market. Picture a bull with horns. What does that bull do when it confronts the matadore? It raises its head and horns up, right? Kind of in a digging fashion! If the value of the stock does not go up but instead goes down, the buyer will allow the option to lapse without exercising the option.
Now, let’s talk about a “put option”. “A put option is the right to sell to the writer (buyer), at any time before a specified future date, a stated number of shares at a specified price. The holder of the stock is generally protecting currently owned stock against a decrease in value.” This is what happens in a bear market. What does a bear do with its prey? It puts it down, doesn’t it? Now, if the value does not decrease, then the buyer will allow the option to lapse without exercising the option.
So, this is clear as mud now, right? Well, read over the above paragraphs again if you have to because we are going to venture “where no man has gone before!” Well, not quite! Let’s talk about taxes now. Remember in my last discussion about gains/losses, we talked about “basis”, eh? If a call is exercised, the buyer must add the cost of the call to the basis of the stock purchased. The seller would increase the amount realized on the sale of the stock by the amount received for the call. If the call expires(because it did not go up as you expected), the you(the buyer) would report the cost of the call as a capital loss on the date of the expiration. The seller, then, would report the amount received for the call as a short-term capital gain (STCG). If the call is sold by the buyer(a.k.a, holder), he/she would report the difference between the cost of the call and the amount received for it as a capital gain or loss (depending on how long it was kept, right?) This sale, though, does not affect the seller.
Now, let’s talk about the tax effects of “puts”. When a put is exercised, the buyer has to reduce the amount realized from the sale of the underlying stock by the cost of the put. On the other hand, the seller will reduce the basis in the stock that was purchased by the amount received for the put. So, what if the put expires (because the option does not go down in price)? Then, the buyer must report the cost of the put as a capital loss as of the date it expired. The seller, then reports the amount received for the put as a STCG. If the put is sold by the buyer, then he/she would report the difference between the cost of the put and amount received for it as a capital gain or loss. And, for the seller there is no effect.
Let’s look at “straddles”. No, cowboy, this is not like riding a horse! In the options trading business, this is where you set up offsetting positions on actively traded property, like, stock and stock options. One might have put and call options on the same number of shares of stock with the same exercise price and period. Sounds risky, eh? Well, this sort of thing is not for the faint of heart, for sure! Typically, one would buy straddles in volatile markets when stocks are expected to make a significant move, either up OR down.
A taxpayer can deduct a loss on a straddle position only to the extent the loss is more than any unrecognized gain on offsetting positions. Then, the unused losses are treated as sustained in the next tax year. Now, as in many things related to the IRS and the complexities of tax law, there are some exceptions, but they are too complicated to go into here. One would report each straddle position on which there is unrecognized gain at the end of the tax year on Form 6781, and ultimately onto Schedule D, Form 1040, Capital Gains and Losses.
Boy, this was fun, eh? Just like taking a buddy with you to swim with alligators – as long as you can swim faster than your buddy, you won’t get bit, right?
Thanks for your time and attention!
Raymond D. Nations, EA
If you find yourself in the lions’ den with the IRS,
Call Ray Nations, Enrolled Agent, to tame that mess!