The circumstances surrounding the profit earned on a call option dictate whether the capital gain is treated as short- or long-term. Short-term capital gains usually apply to assets held for less than a year and are taxed at your ordinary marginal tax rate. Long-term capital gains (on assets held for at least a year) are taxed at 0, 15 or 20 percent, depending on your annual income. In some cases, the determination of a short- or long-term gain is arbitrary and independent of the actual holding period. Call options should not be confused with company stock options, which are granted to employees and operate under different rules.
The tax on options that earn a profit are subject to short- or long-term capital gain rates, similar to the taxes on stocks.
Characteristics of Call Options
A call is a contract that permits (but does not require) the call buyer to purchase a set amount of an underlying asset at a fixed price (the strike price) on or before the call’s expiration date. To purchase a call, the buyer pays the call writer (seller) an amount known as the premium. The premium depends on a number of factors, including the relationship between the call’s strike price and the price of the underlying asset, the time until the contract expires and the price volatility of the underlying asset and the market in which it trades.
Typical underlying assets include stocks, bonds, commodities, commodity futures, security indices and currencies. You can purchase a call on an options exchange or through a brokered transaction (i.e. over the counter). The rights and obligations associated with a call option depend on whether you are the call buyer or writer.
There are three ways to make a profit on a call option:
- Close out your call position for a profit.
- Exercise your call option and sell the underlying asset for a profit.
- Write a call option that expires at a price below the premium you received.
Long and Short Positions
The buyer of a call option holds a long position, which profits when the call increases in value by more than the premium paid to purchase it. For example, if you purchase a call option on 100 shares of XYZ corporation, the option should gain value if the stock price rises. If you paid a $300 premium for the call, the call will be profitable whenever it increases in value by more than $300.
Writers of call options hold the short position, which means they benefit when the price of the call option doesn’t exceed the premium received. A call writer receives an upfront payment of the buyer’s premium, minus any commission and transfer tax. The writer is obligated to sell the underlying asset at the strike price if a long call option expires in the money, that is, the asset price is above the strike price.
When a call holder exercises a call before expiration, the options exchange randomly selects a call writer to make good on the contract, i.e., sell the underlying asset at the strike price to the call holder. The assignment is random, in that any writer of the call can be selected, whether or not the buyer who exercises the call is the same trader who bought the call from the writer.
Outcomes for Call Buyers
Speculators who buy call options generally do not exercise them, but instead look to sell the options at a profit. If you sell your long call position, you report the difference between the sale proceeds and the purchase cost as a short- or long-term capital gain or loss, depending on how long you held the call.
Some investors will exercise their call options as a way to acquire the underlying asset at a bargain price. If you exercise your call option, you add the call’s purchase cost to the cost basis of the underlying asset. This reduces the taxable capital gain or increases the capital loss when you eventually sell the underlying asset. If you hold the underlying asset for a year or longer, you have a long-term capital gain or loss when you sell the underlying asset.
When a call expires, the holder reports a capital loss as of the expiration date. This can be part of a strategy in which hedgers acquire options to protect another investment. For example, if you short a stock (that is, borrow and sell the stock in the hopes of buying it back later at a lower price), you can protect against the stock’s price rising by purchasing calls on the stock. In this trade, if the calls expire worthlessly (i.e. the price of the underlying is less than the call’s strike price on the expiration date), your hope is that the gain on the short stock position is greater than the amount you paid in call option premiums.
Outcomes for Call Writers
When you write a call, you hope that the price of the underlying asset will remain (or fall below) the strike price and the call will expire worthlessly. That’s because you want to pocket the entire premium you receive when you write the call without incurring any further expense. As long as the underlying price is below the call’s strike price, call buyers will not exercise the contract and you will not have to sell the underlying asset. When you write a call that expires, you always treat your profit as a short-term capital gain.
If a call holder exercises the option and you are forced to sell the underlying asset to the holder, you add the premium you received when you wrote the call to the proceeds from the sale of the underlying asset at the strike price. This increases your total proceeds, thus increasing your gain or decreasing your loss. Your holding period for the underlying asset determines whether you treat the capital gain or loss as short- or long-term.
Call writers can close their positions by buying back at the current market price the call options they sold. This is prompted when the price of the call (and the underlying asset) rises, and the call writer wishes to preserve her profit, avoid further losses and/or avoid having to sell the underlying asset to the buyer if the call is exercised. Your total gain or loss is equal to the premium you received when you wrote the call minus the premium you paid when you bought back the call. You always treat this capital gain or loss as short-term.
The 60/40 Rule
Non-equity options belong to a class of financial instruments known as Section 1256 contracts. A non-equity option’s underlying asset is an asset other than stock. These include commodity futures options, debt options, currency options and broad-based stock index options. Section 1256 contracts are subject to the mark-to-market rule, in which you treat any contracts held at the end of the year as if you sold and repurchased them at their final market value for the year, thereby creating a taxable event. Marked-to-market capital gains and losses are treated as 60 percent long-term and 40 percent short-term, regardless of the contract’s actual holding period. The 60/40 rule does not apply to hedging transactions.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.