The best investment decisions invariably are made as the result of thorough evaluation of the features of an investment or strategy, the most important being risk. The evaluation process helps you to avoid mistakes and focus attention on what will be beneficial, given your risk tolerance level. The risk evaluation worksheet for option investing in Table 14.1 will help you to classify options by degrees of risk.

Risk evaluation depends on your analysis of potential profits and losses under all possible outcomes. When considering an option strategy of any nature, first calculate potential profits in the event of expiration or exercise, and then set criteria for other features: maximum time value, time until expiration, the number of contracts involved in the transaction, target rate of return, and the price range at which you will close. Obviously, these criteria will be drastically different for buyers than for sellers, and for covered versus uncovered option writing. Use the option limits worksheet in Table 14.2 to set your personal limits.

Tax Ramifications in Trading Options

An especially complex area of risk involves taxes. If you are like most people, you understand how taxation works, generally speaking. When it comes to options, though, a few special rules apply that can decide whether a particular strategy makes sense.

TABLE 14.2 Option Limits

Capital gains—taxable profits from investments—are broken down into short term or long term. The normal treatment of capital gains is determined by your holding period. If you own stock for 12 months or more and then sell, your profit is treated as long-term gain or loss; a lower tax percentage is applied than to short-term capital gains (gains on assets owned less than 12 months). This rule applies to stocks and is fairly straightforward—until you begin using options as well. Then the capital gains rules change.

Here are 11 rules for option-related capital gains taxes:

1. Short-term capital gains. Generally speaking, any investment you hold for less than 12 months will be taxed at the same rate as your other income (your effective tax rate). After 2003, this rate may be as high as 35 percent. The rate is scheduled to rise in 2010 unless further legislation is passed to change that.

capital gains

profits from investments, taxed the same as other income if the holding period is less than one year, and at lower rates if investments were owned for one year or more.

short-term capital gains

profits on investments held for less than 12 months, which are taxed at the same rate as other income.

long-term

capital gains profits on investments held for 12 months or more, which are taxed at a rate lower than other income.

constructive

sales status when investors buy and sell in separate transactions, but involve substantially identical property; the holding of offsetting long and short positions may be taxed as a constructive sale even when no physical sale has occurred.

2. Long-term capital gains. For investments held for 12 months or more, a more favorable tax rate applies. The maximum rate of 15 percent on long-term gains applies to “net” capital gains (long-term capital gains less short-term capital losses). This rate lasts until the end of 2008 unless future revisions are made to make the favorable rates permanent.

3. Constructive sales. You could be taxed as though you sold an investment, even when you did not actually complete a sale. This constructive sale rule applies when offsetting long and short positions are entered in the same security. For example, if you buy 100 shares of stock and later sell short 100 shares of the same stock, it could be treated as a constructive sale. The same rules could be applied when options are used to hedge stock positions. The determining factors include the time between the two transactions, changes in price levels, and final outcomes of both sides in the transaction. This is a complex area of tax law; if you are involved with combinations and short sales, you should consult with your tax adviser to determine whether constructive sale rules apply to your transactions.

4. Wash sales. If you sell stock and, within 30 days, buy it again, it is considered a wash sale. Under the wash sale rule, you cannot deduct a loss when 30 days have not passed. The same rule applies in many cases where stock is sold and, within 30 days, the same person sells an in-the-money put.

5. Capital gains for unexercised long options. Taxes on long options are treated in the same way as other investments. The gain is short term if the holding period is less than 12 months, and it is long term if the holding period is one year or more. Taxes are assessed in the year the long position is closed in one of two ways: by sale or expiration.

6. Treatment of exercised long options. If you purchase a call or a put and it is exercised, the net payment is treated as part of the basis in stock. In the case of a call, the cost is added to the basis in the stock; and the holding period of the stock begins on the day following exercise. The holding period of the option does not affect the capital gains holding period of the stock. In the case of a long put that is exercised, the net cost of the put reduces the gain on stock when the put is exercised and stock is sold. The sale of stock under exercise of a put will be either long term or short term depending on the holding period of stock.

7. Taxes on short calls. Premium is not taxed at the time the short position is opened. Taxes are assessed in the year the position is closed through purchase or expiration; and all such transactions are treated as short-term regardless of how long the option position remained open. In the event a short call is exercised, the striking price plus premium received become the basis of the stock delivered through exercise.

8. Taxes on short puts. Premium received is not taxed at the time the short position is opened. Closing the position through purchase or expiration always creates a short-term gain or loss. If the short put is exercised by the buyer, the striking price plus trading costs becomes the basis of stock through exercise. The holding period of the stock begins on the day following exercise of the short put.

9. Limitations of deductions in offsetting positions . The federal tax rules consider straddles to be offsetting positions. This means that some loss deductions may be deferred or limited, or favorable tax rates are disallowed. If risks are reduced by opening the straddle, four possible tax consequences could result. First, the holding period for the purpose of long-term capital gains could be suspended as long as the straddle remains open. Second, the wash sale rule may be applied against current losses. Third, current-year deductions could be deferred until an offsetting “successor position” (the other side of the straddle) has been closed. Fourth, current charges (transaction fees and margin interest, for example) may be deferred and added to the basis of the long-position side of the straddle.

offsetting positions

in tax law, a straddle that creates a substantial diminution of risk; when positions are classified as offsetting, tax restrictions are applied on deductibility of losses or treatment of long-term gains.

10. Tax treatment of married puts. It is possible that a married put will be treated as an adjustment in the basis of stock, rather than taxed separately. This rule applies only when puts are acquired on the same day as stock, and when the put either expires or becomes exercised. If you sell the puts prior to expiration, the result is treated as short-term capital gain or loss.

qualified covered call

a covered call that meets specific definitions allowing an investor to claim long-term capital gains tax rates upon sale of stock, or to retain long-term holding period status. Qualification is determined by time to expiration, and by the price difference between current market value of the stock and striking price of the call.

11. Capital gains and qualification of covered calls. The most complicated of the special option-related tax rules involves the treatment of capital gains on stock. This occurs when you use covered calls. The federal tax laws have defined qualified covered calls for the purpose of defining how stock profits are treated; it is possible that a long-term capital gain could be converted to short term if an unqualified covered call is involved. The following section provides the details and examples of how qualification is determined.

Qualified Covered Calls—Special Rules

The tax rules applied when you write in-the-money covered calls are exceptionally complicated. There are several rules to keep in mind to determine whether your in-the-money covered call is qualified or unqualified. With a qualified

Example

Mind-Boggling Limitation: You wrote two covered calls last week. The first one was written with a striking price of 30; the stock’s previous day’s closing price was 32. The call expires in two months. The second call was written with a striking price of 45 and the stock closed the day before at the price of 52. This call expires in three weeks.

The first call is qualified in both respects. The striking price is the first available striking price below the previous day’s stock closing price; and the call is scheduled to expire longer than 30 days out.

The second call is unqualified in both respects. It is not the first available striking price below close (that would have been the striking price of 50). Also, the call is set to expire within the next 30 days.

covered call, your stock does not risk losing its long-term capital gains status; if the covered call is unqualified, then treatment of stock profits changes as a consequence.

If you write out-of-the money covered calls, there is no effect on the status of stock. The following explanation applies only when your covered calls are in the money at the time the transactions are opened.

The general rule governing in-the-money covered calls refers to time. The option must have more than 30 days until expiration. In addition, the striking price cannot be lower than the striking price immediately below the closing price of the stock on the day before you open the covered call.

The rules of qualification are more complex when the call has more than 90 days until expiration. Table 14.3 summarizes the qualification of covered calls given the stock’s closing price in specific stock price ranges, and with various times until expiration.

TABLE 14.3 Qualification of Covered Calls

Example

A Math Challenge: You own shares of stock in several corporations. You want to write covered calls in the money, but you want to ensure that all are qualified. One stock has current market value of $74 per share. To qualify a covered call, it must be one striking price below that level, or 70, if the call is set to expire within 31 to 90 days. If the call is set to expire beyond the 90-day limit, you can write a call two striking prices below the prior day’s close, which is the 65 call. If you write any in-the-money calls other than these, they will be unqualified.

antistraddle

rules tax regulations that remove or suspend the long-term favorable tax treatment of stock when the owner writes unqualified in-the-money covered calls.

What happens when you write an unqualified call? The rules governing the consequences, which are also called the antistraddle rules, affect long-term capital gains qualification of stock. Following is a summary of five ways the rules work:

1. No change for at-the-money or out-of-the-money covered calls. No effect on the tax treatment of stock will be suffered if you write calls with striking prices at or above the closing price of stock.

2. No change for qualified in-the-money covered calls. As long as in-the-money calls fall within the rather limited qualification period (see Table 14.3), no effect will be experienced on the tax treatment of stock.

3. Treatment of capital gains with unqualified covered call. As a general rule, stock you own one year or more is taxed at lower long-term capital gains rates. But when you write an unqualified covered call against stock, the holding period is suspended. This means that counting up to the one-year holding period will not continue as long as the short option remains open.

Example

Coming Up Short: You have owned 100 shares of stock for 11 months. You write an unqualified covered call, and your long-term holding period is suspended. Three months later, the call is exercised and you give up your stock at a profit. Even though you owned the stock for 14 months, your gain is treated as short term. You sold an unqualified covered call, so the period required before long-term rates apply is suspended.

4. Treatment of covered call losses when qualified. Any losses on qualified covered calls are treated as long-term losses when the underlying stock profits are treated as long-term capital gains.

5. Treatment of stock holding period when covered calls are closed. If you sell a covered call at a loss within 30 days of the end of the tax year, you have to hold on to the stock for at least 30 days in order to have the call treated as a qualified covered call.

These rules are exceptionally complicated, and the underlying reasoning for them is puzzling. It certainly requires you to use a qualified tax expert if you do engage in writing in-the-money covered calls. Additional problems may arise when you employ rolling techniques. For example, if you write a qualified covered call today, you satisfy the rules for treatment of the stock if and when the call is exercised. But what happens if the stock’s price rises and you roll forward? The replacement option may end up being unqualified, based on several factors: the current price level of the stock, proximity of the stock’s price to the call’s striking price, and time until expiration. You could unintentionally replace a qualified covered call with an unqualified covered call.

If you are a typical investor, you view a roll as a single transaction: One option is replaced with another. But from the tax point of view, there are two separate transactions. When you close the original short position, you create a short-term capital gain or loss. When you open the second option, you may be either qualified or unqualified in the new option because it is a separate transaction.

carryover

capital losses sums of capital losses from prior years that exceeded annual loss limitation levels; the annual maximum capital loss deduction is $3,000, and all losses above that level have to be carried over and applied in future tax years.

You may question whether it is necessary to master the special and complex tax rules governing covered call qualification. However, the problem is very narrow in focus. It is only a potential problem if you write (or roll forward to) unqualified in-the-money positions. So as long as your calls are at the money or out of the money, you are not affected.

In some situations, you may view writing in-the-money calls as advantageous. For example, you can either sell stock at a profit augmented by option profits, or take advantage of stock price changes by profiting on intrinsic value price movement. If you have large unused carryover capital losses, you may also view the disqualification of stock status as an advantage. Because your annual losses are limited to $3,000, you can use a current-year stock profit as an offset to carryover loss. In this case, you will not be concerned with the loss of long-term favorable treatment.

Example

The Absorption Factor: You had large losses in your portfolio in the years 2000 and 2001. In the current year, you still have over $50,000 in unused carryover capital losses. It will take many years to absorb these losses at the rate of $3,000 per year. However, by selling in-the-money covered calls you create numerous short-term profits, both in calls and in stock exercised against your in-the-money short calls. You view this as one way to shelter short-term profits. Current-year gains are applied against the large carryover loss, so you have no net tax consequences this year.

qualified retirement plans

those plans qualified by the IRS to treat current income as deferred and free of tax in the year earned and, in many cases, also exempting annual contributions to the plan from current taxes.

There are two situations in which you will not be concerned about the loss of favorable long-term capital gains tax rates. First is when you have a substantial carryover loss. Because net investment income can be offset against past-year losses, current-year capital gains—even short-term gains—are fully protected from any taxes.

The second situation is when you are investing through an individual retirement account (IRA) or other retirement plan for which current income is not taxable. In these so-called qualified retirement plans, current income is free of tax, but in future years when withdrawals begin, all income is taxed at ordinary rates. Since you do not benefit from long-term gains rates within such plans, you are free to pursue even aggressive options strategies such as deep in-the-money covered calls.

Looking to the Future

Tax problems and strategies have been made very complex by the current tax rules and, hopefully, future reforms will simplify those rules or make them easier to follow. However, taxes are only one of the many challenges you face in deciding how to plan your investment portfolio, determine which risks are acceptable, and protect capital for your future.

Options, like all investments, should always be used in the context of your individual plans. This is one of the long-term problems with taking advice from individuals whose compensation depends on generating trades: they tend to think in terms of volume rather than starting from the point of view of what works for the client. You need to ensure that your options positions are a logical risk for your portfolio, based on your risk tolerance and personal investing goals.

Example

Defining Yourself and Your Goals: You have written down your personal investing goals, and have identified what you hope to achieve in the intermediate and long-term future. You are willing to assume risks in a low to moderate range. So all of your capital is invested in shares of blue-chip companies. In order to increase portfolio value, you consider one of the following two possible strategies:

Strategy 1: Hold shares of stock as long-term investments. Aim for appreciation and continuing dividend income.

Strategy 2: Increase the value of your portfolio by purchasing shares as described above, and waiting for a moderate increase in value; then begin writing covered calls. As long as your minimum rate of return, if exercised or unchanged, will always exceed 35 percent, you will write a call and then avoid exercise through rolling techniques. If a call is exercised and stock is called away, you plan to reinvest the proceeds in additional purchases of other blue-chip company shares.

In this comparison, the rate of return from the second strategy will always be higher than the first, due to the yield from writing covered calls. A 35 percent rate of return is not unreasonable because it includes the capital gain from selling shares in the event of exercise and because calls can be closed and replaced repetitively. So an annualized double-digit rate is not only possible, it is likely under this strategy. In addition to providing impressive returns, writing covered calls also provides downside protection by discounting your basis in shares of stock.

An interesting point to remember about the covered call strategy, especially as described in strategy 2: The common argument against writing covered calls is that you may lose future profits in the event the stock’s price rises dramatically because your striking price locks you in. It is true that, were the stock’s market value to climb dramatically, you would experience exercise and lose those profits. However, remember that well-selected stocks will also tend to be less volatile than average, so that the chances of such increases—while they can happen—are lower than average. In addition, covered call writers take their double-digit returns consistently in exchange for the occasional lost paper profit. The goal of long-term growth is not inconsistent with writing covered calls, as long as you have a plan and stick to it, and as long as exercised shares are replaced with other shares of equal growth potential.

Every form of investing contains its own set of opportunities and risks. If you lose money consistently in options, you will also tend to have the following characteristics: You do not set goals, so you do not have a preestablished plan for closing positions profitably. You do not select strategies in your own best interests, describing yourself as conservative while using options in a highly speculative manner. You believe in the fundamentals but you follow only technical indicators. You have not taken the time to define your risk tolerance level, so you do not know when the risks you are taking are too high. A popular maxim in the investing community is, “If you don’t know where you’re going, any road will get you there.”

As a successful investor, you are focused. You take the time to define your goals carefully, and you define your risk tolerance level with great care. You also define yourself in terms of what works for you and what doesn’t work. This enables you to use strategies that make sense and to resist temptation when you receive advice from others. You also tend to be patient, and you are willing to wait for the right opportunities rather than taking chances when conditions are not right.

Devising a personal, individualized strategy is a rewarding experience. Seeing clearly what you need to do and then executing your strategy successfully gives you a well-deserved sense of achievement and competence, not to mention control. You will profit from devising and applying options strategies based on calculation and observation. You will also benefit from the satisfaction that comes from mastering a complex investment field, and finding yourself completely in control.

The next chapter examines the potential use of options for specialized trading situations. Because calculations of marginal profits often do not include consideration of the tax consequences, you need to always keep the tax rules in mind when judging various strategic approaches to options trading.