Tax rules for everyday stock trades are fairly simple: if you earn a profit on the sale of a stock, you pay capital gains tax. When you trade stock options -- calls and puts -- things are a bit more complicated. There are several ways options purchase can play out, and all have different tax rules. If you are writing options, it's yet another set of rules.
Stock options trading is a type of futures trading: you buy the right to trade a stock at a specific price at some point in the future. When you purchase a call option, you can buy stock; purchase a put, and you'll be selling. Each option has a "strike price" -- the agreed price for when you exercise the option before it expires. In addition, there are trading costs and premiums for the options writer -- the person or entity that offers the put or call. Calls and puts are bets: if you believe that a stock price is going up, you can purchase a call to buy the stock at today's price. Execute the call next month, when the price is higher, and you can immediately sell the stock for a profit. Puts are the opposite. A put option locks in a sale price so that if the stock price goes down, you will make a profit.
Tax Rules for Options Purchasers
You pay no tax on a call or put until one of three things happens: the option expires, is exercised or is sold. If an option expires, it's treated like a sale for tax purposes -- you may write off the cost of purchasing the option as a capital loss. This loss is short-term if you held the option for less than a year, long-term if you held it for a year or more. If you exercise an option, all the costs associated with the option become part of the purchase price of the stock, known as the tax basis, and offset the capital gain and associated tax for the sale of the stock. If you sell an option, you can treat it like the sale of stock: you have a gain or loss that is short-term if you held the option for a year or less, and long-term if held longer.
Tax Rules for Options Writers
If you write an option, the buyer pays you a premium for that opportunity. This premium is not included in your income until the option is exercised or expires. You must treat the premium as a short-term capital gain for tax purposes as of the expiration or exercise date. Options premiums are never treated as long-term gain, regardless of the time between sale of the option and expiration or exercise.
Trader Status and Straddles
If you trade a lot -- 20 or more hours per week and at least 1,000 short-term trades per year, the IRS considers you a "trader" for tax purposes. Trades can be options or other types of stock market activity. This moves you from hobbyist to business person and the tax rules are very different. In addition, if you straddle your options positions by investing in offsetting stock positions, there is another set of tax rules. Either of these situations necessitates a conversation with an accountant or tax planner to ensure that you understand your tax obligations so that you can maximise your profits and avoid IRS penalties.