Taxation of Option Trades

Scope note from the text

You learned several options strategies in the options unit.

This chapter focuses on the tax consequences of options. The topics here assume you already know the basic option strategies.

🔑 In general, you’ll need to know the tax consequences relating to five topics:

Expiration

When an investor buys or sells an option, there are three potential outcomes:

Worked example — long call expires

An investor goes long 1 ABC Jan 50 call at $4 when ABC’s market price is $51. Several months later, the ABC’s market price falls to $49 and stays there until expiration. What is the tax consequence?

Answer = $400 capital loss

The investor bought a call, and it expires out of the money (no intrinsic value). Calls expire worthless if the market price is below the strike price at expiration. The investor paid $400 for the option and receives nothing at expiration, so they realize a $400 capital loss.

Worked example — short put expires

One August 80 put is written for a premium of $7 when the underlying stock’s market price is $78. Just prior to expiration, the stock’s market price rises to $90. What is the tax consequence?

Answer = $700 capital gain

The writer sold a put, and it expires out of the money (no intrinsic value). Puts expire worthless if the stock’s market price is above the strike price at expiration. The investor keeps the $700 premium and is not assigned, so they realize a $700 capital gain.

Trading (closing out)

Before exercise or expiration, an options investor can trade out of the position (close it out).

Worked example — closing a long put

An investor goes long 1 XYZ Dec 35 put at $5 when XYZ’s market price is $36. XYZ’s market price falls to $32, and the investor closes the contract at intrinsic value. What is the tax consequence?

Answer = $200 capital loss

To find the gain or loss, compare what the investor paid to open the position to what they receive when they close it.

The put cost $500 to buy ($5 × 100). When XYZ falls to $32, the put is in the money by $3 ($35 − $32). Closing at intrinsic value means the investor sells the option for $300.

Buying for $500 and later selling for $300 produces a $200 capital loss.

Worked example — closing a short call

A client of yours writes 1 ZZZ Sep 60 call for a premium of $4. A few months later, the investor closes the position at $3. What is the tax consequence?

Answer = $100 capital gain

The client initially sold (wrote) the contract for $400. To close a short option position, the client must buy the contract back.

Premium received: $400 Cost to close (buy back): $300

The difference is a $100 capital gain.

Exercise

Definitions

🔑 Master table — exercise treatment by option type and side

Worked example — long call exercised

An investor goes long 1 BCD Apr 25 call at $3. BCD’s market price rises to $30, and the investor exercises the option. What is the tax consequence?

When the call is exercised, the investor buys 100 BCD shares at $25. Because the investor is buying stock, exercise establishes cost basis.

Start with the strike price ($25). Then incorporate the option premium. Since the investor paid the premium to buy the call, the premium is added to the cost basis.

Strike price: $25 Premium paid: $3 Cost basis: $28 per share

A quick way to double-check is to use breakeven. At exercise, the cost basis (or sales proceeds) will equal the option’s breakeven. For a call, breakeven is strike price + premium: $25 + $3 = $28.

Worked example — short call assigned

A CDE Sep 75 call is written for $6 when CDE’s market price is $74. CDE’s stock price rises to $79, and the option is assigned. What is the tax consequence for the writer?

Answer = $81 sales proceeds (per share)

When a written (short) call is assigned, the writer must sell 100 shares at the strike price ($75). Because the writer is selling stock, exercise establishes sales proceeds.

Start with the strike price ($75). Then incorporate the option premium. Since the writer received the premium, the premium is added to sales proceeds.

Strike price: $75 Premium received: $6 Sales proceeds: $81 per share (or $8,100 total)

Worked example — long put exercised (stock + option combined)

An investor goes long 100 shares of PEP stock at $120. A few months later, they go long 1 PEP Feb 120 put at $9 when PEP’s market price is $115. A few weeks later, PEP’s market price falls to $105, and the investor exercises the option. What is the tax consequence for both the stock and option?

Answers:

Stock = $120 cost basis (per share) Option = $111 sales proceeds (per share) Overall = $9 capital loss

This question combines stock and an option.

The stock’s cost basis is what the investor paid for the shares: $120 per share.

When the long put is exercised, the investor sells the shares at the strike price ($120). Because the investor is selling stock, exercise establishes sales proceeds.

Start with the strike price ($120). Then incorporate the option premium. Since the investor paid the premium to buy the put, the premium is subtracted from sales proceeds.

Strike price: $120 Premium paid: $9 Sales proceeds: $111 per share

To find the overall tax consequence on the stock sale, compare cost basis to sales proceeds:

Cost basis: $120 Sales proceeds: $111

That produces a $9 per share capital loss (or $900 total).

Worked example — short put assigned

An investor writes 1 CBA Jun 150 put at $12 when CBA’s market price is $145. CBA’s market price falls slightly to $143, and the option is assigned. What is the tax consequence?

Answer = $138 cost basis (per share)

When a written (short) put is assigned, the writer must buy 100 shares at the strike price ($150). Because the investor is buying stock, exercise establishes cost basis.

Start with the strike price ($150). Then incorporate the option premium. Since the investor received the premium for writing the put, the premium is subtracted from cost basis.

Strike price: $150 Premium received: $12 Cost basis: $138 per share (or $13,800 total)

Put hedges

Long puts protect long stock positions (see the hedging strategies chapter). A long put can affect a stock’s holding period (long-term or short-term). There are three potential scenarios when an investor owns stock and purchases a protective put.

🔑 Three scenarios at a glance

Scenario #1 — Married put

If an investor buys the stock and the put on the same day, the position is known as a married put. The name reflects how the IRS treats the position for tax purposes: the stock and put are treated as a single combined position.

The put premium is added to the stock’s cost basis. The option is essentially ignored for tax reporting purposes.

An investor purchases 100 shares of WMT stock at $170 per share and goes long 1 WMT 165 put at $4 on the same day.

The stock’s cost basis becomes $174 per share ($170 + $4). Even if the put expires, there is no separate capital loss reported for the option. Instead, the $4 premium remains embedded in the stock’s cost basis, which reduces taxable gains when the stock is sold.

Married puts do not affect the stock’s holding period. If the stock is held for over a year, the sale produces a long-term capital gain or loss. If held for a year or less, the sale produces a short-term capital gain or loss.

Scenario #2 — Put bought on a different day (short-term shares)

If the put is bought on any day other than the day the stock is purchased, it can affect the holding period. Also, the put’s premium is not added to the stock’s cost basis (the stock and option are tracked separately).

An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 eleven months later, and the investor goes long 1 WMT 190 put at $6.

At this point, the investor is close to long-term status. With the protective put in place, the investor can exercise and sell at $190 even if the market price drops, which limits downside risk.

For this reason, the IRS nullifies and resets the investor’s holding period to zero until the put is closed out or expires. Practically, the stock has no running holding period while the put is in place. Once the put is closed or expires, the holding period starts again from zero.

Scenario #3 — Shares already long-term (exception)

One exception to the rule discussed above is if the shares were already long-term.

An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 thirteen months later, and the investor goes long 1 WMT 190 put at $6.

Because the stock is already long-term at the time the put is purchased, the holding period is unaffected.

Holding periods

When an options contract is traded or expires, the reported gain or loss is almost always short-term. Standard contracts maintain a maximum expiration of 9 months. A security held for a year or less is considered short-term and is subject to higher tax rates.

Definitions

🔑 Holding period rules

Key points

Option expiration tax consequence

• Capital gain or loss equal to the premium

Option trading tax consequence

• Capital gain or loss equal to the overall gain or loss

Option exercise tax consequence

• Establishes cost basis if shares purchased
• Establishes sales proceeds if shares are sold
• Premium must also be factored

Married puts

• Long stock and long put on same day
• Put’s premium is added to stock’s cost basis
• Does not affect the holding period

Non-married puts

• Long stock and long put on separate days
• Put’s premium is not added to the cost basis of stock
• Holding period nullified and reset to zero if shares held short-term
• Holding period stuck at zero until put expires or is closed

LEAPS

• Long-term equity anticipation securities
• Options with expirations of up to 39 months

Option holding periods

• Capital gains and losses are generally short-term
• Long LEAPS may be long-term if held for longer than one year
• Short LEAPS are always short-term
• Short securities are ineligible for long-term status

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.