1.9 Futures, ESOs & Derivative Tax
This chapter covers the derivative products that sit outside plain stock and option strategies: futures and forwards, employee stock options, the tax treatment of option trades, and which investors each derivative suits. It matters because the exam asks how similar contracts differ and how each tax event is reported, and because a client’s risk tolerance decides whether a derivative strategy is appropriate at all.
What each topic covers
Futures vs. Forwards compares two contracts that both lock in a price today for a future transaction, with the buyer obligated to buy (bullish) and the seller obligated to sell (bearish). Futures are standardized and trade on exchanges, so liquidity risk is low, and more than 95% are closed out rather than delivered. Forwards are customized, have no trading market, carry high liquidity risk, and mostly end in delivery, so they serve people who work directly with the commodity.
ISO vs. NSO Taxation sets the two employee stock options side by side. Neither is taxed at grant. An NSO is taxed at exercise as ordinary income (up to 37%) on its intrinsic value, then again at sale as a capital gain. An ISO, which only employees can receive, is not taxed at exercise, and its gain is long-term (15% or 20%) only if the shares are sold at least two years from grant and over one year from exercise.
Taxation of Option Trades walks through five topics: expiration, closing out, exercise, put hedges and holding periods. Expiration produces a capital gain or loss equal to the premium, and closing out produces the contract’s overall gain or loss. Exercise instead sets cost basis or sales proceeds on the stock, with the premium added or subtracted depending on the position. The lesson also covers married puts, the reset of a short-term holding period, and why short LEAPS are always short-term.
Derivative Risk & Investor Profile matches strategies to investors. Long options are speculative growth for aggressive investors, and uncovered short options are speculative income with very high risk tolerance. Hedges such as protective puts depend on the position they protect. Covered calls suit virtually all investors if the stock position is suitable, while covered puts are very risky because the short stock has unlimited risk.