Gains and losses on call and put options can be subject to capital gains tax or income tax. It depends on several factors, including how long you’ve held them in some cases. It’s important to have a basic understanding of tax laws before you begin trading options because you’ll almost certainly trigger taxes at some point.
Key Takeaways
- Chances are that you’ve triggered some taxable events that must be reported to the IRS if you’re trading options.
- Many options profits are classified as short-term capital gains.
- The method for calculating gains or losses will vary by strategy and holding period.
- Exercising in-the-money options, closing out a position for a gain, or engaging in covered call writing will all lead to somewhat different tax treatments.
Exercising Options
You might be subject to income tax or capital gains tax when you’re exercising options depending on how long you’ve held them and some other factors. The taxable amount depends on which type of option you exercise.
Call Options
The premium paid for an option is included in the cost basis of the stock purchase when call options are exercised. Let’s say a trader buys a call option for Company ABC with a $20 strike price and a June expiry. The trader buys the option for $1 or $100 total because each contract represents 100 shares. The stock trades at $22 upon expiry and the trader exercises the option. The cost basis for the entire purchase is $2,100. That’s $20 x 100 shares plus the $100 premium, or $2,100.
Now let’s say it’s August and Company ABC is trading at $28 per share. The trader decides to sell their position. A taxable short-term capital gain of $700 is realized. That’s $2,800 in proceeds minus the $2,100 cost basis or $700. Commissions can be included but there are none in this example.
The trader exercised the option in June and sold the position in August so the gains from the sale are considered a short-term capital gain. The investment was held for less than a year.1 But short puts and short calls are always treated as short-term gains or losses regardless of the holding period.2
Put Options
Put options receive a similar treatment. The put’s premium and commissions are added to the cost basis of the shares if a put is exercised and the buyer owns the underlying securities. This sum is then subtracted from the shares’ selling price. The position’s elapsed time runs from when the shares were initially purchased to when the put was exercised and the shares were sold.
Similar tax rules to a short sale apply if a put is exercised without prior ownership of the underlying stock. The period starts from the exercise date and ends with the closing or covering of the position.3
Investopedia does not provide investment advice. This article serves only as an introduction to the tax treatment of options. Tax laws regarding options and trading are complex. Further due diligence or consultation with a tax professional is recommended.
Pure Options Plays
Both long and short options for the purposes of pure options positions receive similar tax treatments. Gains and losses are calculated when the positions are closed or when they expire unexercised. In the case of short call or put writes, all options that expire unexercised are considered short-term gains.3 Here are some examples that cover some basic scenarios.
Taylor purchases an October 2023 put option on 100 Company XYZ shares with a $50 strike in May 2023 for $3. They subsequently sell back the option when Company XYZ drops to $40 in September 2023 for $2 so they would have a short-term loss of $100 ( [ $3 x 100 shares ] – [ $2 x 100 shares ] ).
Taylor is eligible for a short-term capital loss of $100 ( [ $4 x 100 shares ] – [ $5 x 100 shares ] ) if they write a $60 strike call for 100 Company XYZ shares in May, receiving a premium of $4 with an October expiry, and decide to buy back their option in August when Company XYZ jumps to $70 on blowout earnings for $5.
Taylor will realize a long-term capital loss, however, on their unexercised option equal to the premium of $400 ($4 x 100 shares) if they purchased a $75 strike call for 100 Company XYZ shares for a $4 premium in May with an October expiry in the next year and the call is held until it expires unexercised. They owned the option for more than one year, making it a long-term loss for tax purposes and Taylor did not sell the option. It expired.2
Covered Calls
Covered calls are slightly more complex than simply going long or short on a call. Someone who is already long on the underlying security will sell upside calls against that position with a covered call, generating premium income but also limiting upside potential. Taxing a covered call can fall under one of three scenarios for at- or out-of-the-money calls:
- Call is unexercised
- Call is exercised
- Call is bought back (bought-to-close)
Taylor owns 100 shares of Microsoft Corporation (MSFT) on Jan. 3, trading for $46.90. They write and sell a $50 strike-covered call with a September expiry, receiving a premium of $0.95:
