Basic rules
You learned several options strategies in the strategies unit. In this chapter, we’ll discuss the basic tax consequences of options. The topics covered require a baseline knowledge of options; click the link above to review various strategies. We’ll cover tax consequences related to:
- Expiration
- Trading
- Exercise
Expiration
When an investor buys or sells an option, there are three potential outcomes:
- Expiration
- Trading the contract (closing out)
- Exercise
We’ll discuss the expiration of options contracts in this section. When an options contract expires, the result is a capital gain or loss equal to the premium. It’s as simple as that! Let’s take a look at an example:
An investor goes long 1 ABC Jan 50 call at $4 when ABC’s market price is $51. Several months later, the ABC’s market price falls to $49 and stays there until expiration. What is the tax consequence?
Can you figure it out?
Answer = $400 capital loss
The investor buys a call, and it subsequently goes “out of the money” (no intrinsic value). Remember, calls expire if the market price is below the strike price at expiration. The investor paid $400 for the option and didn’t get any use out of it. Therefore, they realize a capital loss of $400.
Let’s try another example:
One August 80 put is written for a premium of $7 when the underlying stock’s market price is $78. Just prior to expiration, the stock’s market price rises to $90. What is the tax consequence?
Answer = $700 capital gain
The writer sells a put, and it subsequently goes “out of the money” (no intrinsic value). Puts expire if the stock’s market price is above the strike price at expiration. The investor received $700 for the option and wasn’t assigned (exercised). Therefore, they realize a capital gain of $700.
Trading
Before an exercise or expiration, an options investor can trade out (close out) of the position. This concept was covered in the issuance & the market chapter. From a tax perspective, investors realize capital gains or losses equal to a contract’s overall gain or loss. Let’s take a look at an example:
An investor goes long 1 XYZ Dec 35 put at $5 when XYZ’s market price is $36. XYZ’s market price falls to $32, and the investor closes the contract at intrinsic value. What is the tax consequence?
Answer = $200 capital loss
The price paid for the option must be compared to the premium received at the closing sale to determine the overall gain or loss. The put cost $500 to establish the position. When the market falls to $32, the contract is “in the money” by $3. Therefore, the investor performs a closing sale of $300. Buying the contract for $500 and later selling it for $300 results in a net $200 capital loss.
One more example:
A client of yours writes 1 ZZZ Sep 60 call for a premium of $4. A few months later, the investor closes the position at $3. What is the tax consequence?
Answer = $100 capital gain
The client initially sold (wrote) the contract for $400. Later, the client performs a closing purchase (must buy the contract to close a short position) at $300. This results in a net $100 capital gain.
Exercise
Taxes related to exercising contracts are more complicated than expiration or trading. Instead of a capital gain or loss, an exercise establishes cost basis or sales proceeds on the underlying security (usually stock). Cost basis represents the overall cost to purchase a security, while sales proceeds represents the overall liquidation value to sell a security. Let’s go through an example together:
An investor goes long 1 BCD Apr 25 call at $3. BCD’s market price rises to $30, and the investor exercises the option. What is the tax consequence?
The investor buys 100 BCD shares at $25 when the call is exercised. Because they’re buying stock, the investor establishes cost basis. If they sold stock instead, the investor would establish sales proceeds. Determining if it’s cost basis or sales proceeds has nothing to do with buying or selling the option - it’s all about the action taken with the stock at exercise!
A $25 cost basis is the starting point. The option premium also needs to be factored in. Because the investor bought the option as well, we add the premium to the cost basis. The cost basis reflects the total cost of obtaining a security. In this scenario, the investor bought the option for $3 and the stock for $25, leading to an overall cost basis of $28 (per share).
A way to double-check your answer is to find the option’s breakeven. The cost basis (or sales proceeds) will always equal the option’s breakeven. You can find the call’s breakeven by adding the strike price ($25) to the premium ($3), which adds up to $28. This is a trick you can use to answer exercise-based tax questions.
Let’s see if you can make it through three more examples on your own:
A CDE Sep 75 call is written for $6 when CDE’s market price is $74. CDE’s stock price rises to $79, and the option is assigned. What is the tax consequence for the writer?
Answer = $81 sales proceeds (per share)
When the short (written) call is assigned (exercised), the investor is forced to sell 100 CDE shares at $75. Because they’re selling stock, they’re establishing sales proceeds.
A $75 sales proceeds is the starting point. The option premium also needs to be factored in. Because the investor sold the option as well, the premium is added to the sales proceeds. Sales proceeds measure the liquidation (sale) value of a security. In this scenario, the investor sold the option for $6 and the stock for $75, leading to an overall cost basis of $81 per share (or $8,100 overall).
Let’s look at some put contract examples:
An investor goes long 100 shares of PEP stock at $120. A few months later, they go long 1 PEP Feb 120 put at $9 when PEP’s market price is $115. A few weeks later, PEP’s market price falls to $105, and the investor exercises the option. What is the tax consequence for both the stock and option?
Answers:
- Stock = $120 cost basis (per share)
- Option = $111 sales proceeds (per share)
- Overall = $9 capital loss
This question is tricky because it adds stock into the mix. The easiest part is the cost basis, which is the price paid for PEP stock ($120).
When the long put is exercised, the investor sells the 100 shares of PEP stock at $120. Because they’re selling stock, the investor establishes sales proceeds.
A $120 sales proceeds is the starting point. The option premium also needs to be factored in. The option was purchased, so the premium is subtracted from the sales proceeds. The investor bought the put for $9 and sold the stock for $120, leading to an overall sales proceeds of $111 per share.
To find the overall tax consequence, compare the $120 cost basis to the $111 sales proceeds. This results in a net capital loss of $9 per share, or $900 overall.
One last example involving put contracts:
An investor writes 1 CBA Jun 150 put at $12 when CBA’s market price is $145. CBA’s market price falls slightly to $143, and the option is assigned. What is the tax consequence?
Answer = $138 cost basis (per share)
The investor buys 100 CBA shares at $150 when the option is assigned (exercised). Because they’re buying stock, the investor establishes cost basis.
A cost basis of $150 is the starting point. The option premium also needs to be factored in. The option was sold, so the premium is subtracted from the cost basis. The investor sold the put for $12 and bought the stock for $150, leading to a total sales proceeds of $138 per share (or $13,800 overall).
This video summarizes the option taxation concepts we’ve discussed in this chapter:
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