Saturday, December 23, 2006

PUTS AND CALLS --their nature and their TAXATION

-To understand the tax handling of puts and calls you need to understand what they are and terms like ‘strike price’, ‘intrinsic value’ and ‘premiums’ as well as the tax rules.
You buy a call on a stock you expect to go up.
You sell a call on a stock you own-- or maybe even a stock you don’t own --if you expect the price to remain unchanged or go down.
You sell a put if you expect the stock to go UP (or remain unchanged) —or buy a put if you expect the price to decline or remain unchanged.
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Before getting into tax rules, the nature of these options here is some of the terminology:
Intrinsic value, premium and strike price of an option:
These options have an “intrinsic” value equal to their ‘in-the-money’ value, but sell at something more than the intrinsic value. A $ 40 option on a $ 45 stock has an intrinsic value of $ 5.00, but if you bought it for only $ 5.00 it would be like getting an interest-free loan, so you pay a premium to the seller who takes the risk that the stock may go up through the roof and he is obligated to sell it for only $40 plus the $5 plus the premium he got for the sale of the option. In this example the $40 figure would be called the ‘strike’ price'.

In-the-money and out-of-the-money options:
A $ 40 call option on a $45 stock would be in the money by $ 5.00 which would be it’s intrinsic value. Anything you pay to buy it in excess of $ 5.00 would be the premium. In this case the ‘strike price’ is $ 40.
A $ 40 (strike price) call option on a $35 stock would be an out-of-the-money option and would have no intrinsic value, yet you couldn’t get it for nothing, so what you pay is the premium..
For puts a $ 40 strike price would be in-the-money if the price of the stock was $45 and would be out-of-the money if the stock's price was $35

Puts are more difficult to understand than calls because we think in terms of buying preceding selling.. Buying a put is similar to short-selling, except you are BUYING something instead of selling something you don't own--i.e. you achieve an effect similar to selling short. .

A put gives the purchaser the right to sell a stock at a certain strike price . If a stock is selling for $ 49 and you expect it to rise quickly to $ 55, you sell someone the right to buy it from you at $ 50 (the strike price) and hope it will expire worthless. The buyer may own the stock and would buy the put to protect himself if the price dropped to $40. However, the buyer may not own the stock but expects it to drop to $ 40, so he could make $9.00 minus the cost of the put if he is correct. If the stock goes up to $ 100, he would lose a lot more than the amount he got for selling the put--since, if he would either have to buy back the put for a lot more than he sold it for or would have to buy the stock at $ 100 in order to sell it to someone exercising the put and buying it from you for $50.
My personal experience in selling puts:
Back in the days of the dot com craze, I used to sell puts on QQQ (now QQQQ) for large premiums. The puts would then expire worthless because the stock went up. I was $ 60,000 ahead when QQQ began to drop like a rock and I lost all my profits. As the stock dropped, buyers of the puts made out like bandits.
A Call is a little more straight forward. You buy if you expect the stock to rise and sell if you expect it to drop or stagnate. If you own the stock you sell a ‘covered’ option. If you don’t own it, then you are selling a ‘naked’ call option. In the case of a put, the only way you would be selling a ‘covered’ put would be if you had sold the stock short.

If you bought a $40 call and the stock went to $ 45, you may either sell the call before it expires or you may exercise it and get a $ 45 stock for $ 40. In that case your cost basis is $ 40 cost of the stock plus the price you paid for the option. The guy who sold the call would show a sale in the amount of the $40 plus the price he sold it for.
If the $ 40 call expires worthless because the price of the stock dropped to $ 35, you would report the cost of the call as a capital loss on the date it expired.
You buy a $ 40 call for $ 1.00 per share when the stock is selling for $ 39.00
You sell a call at a gain:
The stock then goes up to $ 45 several weeks before the expiration date.
You may decide to cash in before it drops back to $ 39 or $ 40, so you sell it for $ 6.00 for a $5.00 profit on a $ 1 investment. You would have a capital gain of the $5.00.
You exercise the call:
The stock goes up to $ 45. You exercise the call and get the stock for $40. Your cost basis is the $ 40 plus what you paid for the call. The seller of the call would increase the amount the got for the stock by the amount he got for selling the call.
You sell the call at a loss:
If the price of the stock went down and you decided to cut your loss, you might sell it for 50 cents. Then you, the buyer, would have a 50 cent capital loss. actually be 50 cents times 100 shares. A sale by the holder of the call does not affect the seller of the call.
The call expires worthless:
The call expires and the stock is still selling at $ 39 or less:
If the call expires worthless, you, the buyer, have a short-term capital loss, The seller of the call would have a short-term capital gain for the amount for which he sold the call

Assume the market looks like it is peaking out so you decide to buy some puts on a $41 stock. You buy a $40 put for $1. It has no intrinsic value, but it will if the stock nosedives.
You exercise the put:
The stock drops to $ 30 and you have a profit of $10 minus what you paid for the put.
If you own the stock you can exercise the put and “put it to” the buyer at $40 even though it is only selling for $ 30 on the market. You would Reduce the $40 sale by the $1 you paid for the put and report the gain or loss based on a $39 sale. The seller would reduce his basis in the stock by the amount he got for selling the put.
You sell the put at a gain:
If you don’t own the stock and don’t want to buy it, then you could sell the put and would have a gain in the amount of the sales price minus the cost of your put. Your action does not affect the seller.
You sell the put at a loss:
The stock goes up to $ 45, so no one is going to pay you as much as you paid for the option when it was selling at $ 40, so you may sell it for 50 cents since it now looks like it may expire worthless. The buyer thinks otherwise. A sale would result in a short term capital loss to you, the seller. The buyer of the option you sold would not be affected at this point.
The put expires worthless:
If the stock stays at $ 41 or the price rises and your put expires worthless. You, the buyer, would then have a capital loss on the date of expiration. The seller of the put would have a short term capital gain.

Warning: Puts and calls can be hazardous to your wealth (as I learned)
Before engaging in buying or selling puts and calls you should become familiar with the risks involved. The above discussion does not cover everything you need to know, but may be a helpful starting point. Selling a call can cause you to sell too soon in a rising market. Selling a put can result in some big losses in a rising market. Buying either a put and call causes you to lose the premium you paid since it is a wasting asset and only one of thee things can happen: the stock can go the wrong direction or it can make little or no move and the buyer of the option would have a loss. He can only gain if the stock moves in the direction he is hoping for and in sufficient amount to more than cover the premium he paid over and above its ‘intrinsic’ value. You are more likely to make money selling options than in buying them, but you assume very big risks and could lose big-time.

References: Schedule D, Form 1040, Pub. 550, Pub 554 IRC §1221
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This information is not intended to be advice to the recipient.In compliance with Treasury Department Circular 230, unless stated to the contrary, any Federal Tax advice contained in this Blog was not intended or written to be used and cannot be used for the purposes of avoiding penalties.

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