I want to cover an important topic that is a little more technical, so put on your thinking caps!
I’m talking about options trading.
Options are by no means new, and I’ve talked about it options plenty of times before. But I find options trading is something that many traders are scared of because they don’t understand it.
And it makes sense!
You shouldn’t trade something that you don’t understand. So I wanted to take some time and explain options briefly and then look at some of the finer nuances of options trading.
That way, whether you are new to trading, or you have been doing it for a while, you can trade with more confidence!
What are Options
An option is a contract between two parties that grants the owner the right — but not the obligation — to buy or sell shares of an underlying security at a specified price (the strike price) on or before a given date (the expiration date).
U.S.-listed options generally expire on the third Friday of the month.
In the rare event that the Friday is a holiday, the options expire on the preceding Thursday instead.
There are two basic types of options:
A call option gives its holder the right — but not the obligation — to BUY an underlying security.
A put option gives its holder the right — but not the obligation — to SELL an underlying security.
Each options contract covers 100 shares of any given security, known as a round lot.
There are options actively trading on most major stocks and ETFs, and investors frequently use these investments as a way to hedge their portfolios or to speculate on a security’s future moves.
How Options are Traded
One advantage of using options like this is that investors put less capital at risk — because buying a contract allows you to control 100 shares for a lot less money than it would take to buy the shares outright.
Plus, when buying options, they have strictly limited downside, which is not technically the case with other speculative activities like short selling.
Of course, in addition to buying options, you can also SELL options to generate additional investment income.
You see, most investors who use options to speculate never think about where the options actually come from.
Yet the reality is that options come from other investors willing to take on the specific obligation of the contract, in a process known as option writing.
An investor who writes a call is willing to sell the security covered by the contract at the specified strike price up until the option’s expiration day.
And an investor who writes a put is willing to buy the security covered by the contract at the specified price up until the option’s expiration day.
Now, here’s something a lot of options investors – maybe even sophisticated ones – fail to consider: Taxes!
How Taxes on Options Work
Take someone who sells a put option to generate income upfront, which is a strategy I heartily endorse.
Let’s say their trade goes through on December 31st of a given year.
Do they report the income for that year?
The income is only reportable once:
1) The option expires.
2) The option is exercised
3) The seller buys back the same contract to close out the trade.
This is a really interesting fact that a lot of people miss.
It might even affect which particular option contract someone wants to sell.
For example, the difference between selling a contract expiring in December vs. one expiring in January could mean an entire year of deferred taxes on the proceeds!
Meanwhile, if the option gets exercised, you simply use the premium collected to reduce your cost basis in the underlying shares that were put to you. Your holding period for the stock begins the day after you acquire the stock.
In the third case, when a seller buys back the contract to close the trade, a so-called “offsetting transaction,” your short-term gain or loss is the difference between the premium you originally collected minus the amount you paid to buy back the same contract.
It’s the same basic idea when selling covered calls, too. Under the second scenario above, you simply add the premium you collected to the gain (or loss) achieved on the underlying stock sale.
What about anyone buying options for more speculative purposes?
It’s pretty similar to the rules I just outlined for selling options with a few additional concepts to consider.
For starters, your gain or loss can be either short-term or long-term in nature. The dividing line is 12 months. It doesn’t really matter whether you sold the option or it expired. Whatever year the result happened is the year you report it for.
Meanwhile, if you exercise a put option you deduct the premium cost (and associated commissions) from the money you received when you sold the stock.
One Last Twist
If you happen to exercise a call option you bought, you add the premium you paid into your cost basis for the shares themselves.
But what’s interesting is that your holding period for the stock begins the day after you received the shares – i.e. the day after you exercised the option. You do not receive credit for the time you effectively controlled the shares with the option itself.
Obviously, if you’re doing your option trading inside of a tax-sheltered account like an IRA then none of this matters to you at all.
But if you’re using a regular taxable account, then understanding how various options strategies get treated by the IRS is important … and could even influence what contracts you select and what strategies you implement.
To a richer life,
— Nilus Mattive
Editor, The Rich Life Roadmap
Source: Daily Reckoning