If you’re an options trader wondering about taxes, you’re in the right place …
Let’s be honest: taxes are no fun, but by understanding how option trades and their gains and losses are taxed, you can determine how much your tax burden will eat into your profit — and this can help you re-work your options trading strategy to account for it.
Let’s get started!
The Basics: Short-Term vs. Long-Term Gains
First off, the IRS treats gains from options as either short-term or long-term capital gains.
- Short-term means you held the option or the underlying stock for a year or less. These gains get taxed like your regular income, which can be up to 37% depending on your tax bracket.
- Long-term means holding for more than a year, and those gains get a friendlier tax rate — usually 0%, 15%, or 20%.
So, how long you hold your options or stocks really matters.
What Happens When You Exercise a Call Option?
Imagine you bought a call option to buy 100 shares of a stock at $20 each, and you paid $1 per share for that option. When you exercise it (meaning you actually buy the stock at $20), your cost basis isn’t just $20 per share — you add the $1 premium you paid. So, your total cost basis is $21 per share.
If you then sell the stock later at $28 per share, your profit is $7 per share ($28 minus $21). If you sold it within a year of exercising, that’s a short-term gain and taxed accordingly.
What About Put Options?
Put options work a bit differently. If you own the stock and buy a put option to protect yourself, the premium you pay adds to your cost basis when you sell the stock.
But if you exercise a put option without owning the stock first (like selling short), the holding period starts from the day you exercise the option.
Any gains or losses from that point are usually short-term if you close the position within a year.
Expiring or Closing Options Early
If you let your option expire worthless, you can usually claim a loss equal to the premium you paid. If you close your option position early by selling it, your gain or loss depends on the difference between what you paid and what you sold it for.
Keep in mind: short puts and short calls are always treated as short-term gains or losses, no matter how long you hold them.
Covered Calls and Protective Puts
If you own shares and write (sell) covered calls against them, the tax treatment depends on whether the call is exercised, expires, or you buy it back.
- If the call expires unexercised, the premium you received is a short-term gain, even if you held the shares for a long time.
- If the call is exercised, your gain or loss depends on your total holding period and cost basis of the shares.
- If you buy the call back, your gain or loss depends on the price difference and how long you’ve held the position.
Protective puts can help shield your stock position, but they can also affect your holding period and tax treatment, so be mindful of that.
Watch Out for the “Wash Sale” Rule
This one’s important: if you sell a stock or option at a loss and buy a “substantially identical” security within 30 days, the IRS says you can’t claim that loss right away. Instead, the loss gets added to the cost basis of the new security.
So, if you’re actively trading options and stocks, be careful about timing your buys and sells to avoid triggering this rule.
Quick Recap: Taxes on Calls and Puts
It’s a lot to take in, I know. Before we wrap up, let’s take another quick look:
- Gains on options can be short-term or long-term depending on how long you hold them or the underlying stock.
- Exercising calls adds the premium to your stock’s cost basis.
- Exercising puts adjusts your sale proceeds or starts a new holding period if you don’t own the stock.
- Covered calls and protective puts have special tax rules.
- The wash sale rule can delay your loss deductions if you buy back similar securities too quickly.
- Complex strategies like straddles have their own tax quirks.
Final Thoughts
Understanding the taxes associated with options trading isn’t the most fun experience, but it can help you understand your tax burden.
Since tax laws can change, we recommend being committed to knowing them, and if your trading strategy gets more complex, it’s always a smart move to chat with a tax pro who knows options trading.