When someone owning shares of stock sells an option that would allow someone to buy those shares, the seller of the option is using a covered call strategy. The option is a call because it’s an option to buy, not an option to sell (which would be a put option). And because the person selling the option owns shares that can be used to meet the obligation to deliver stock if the option is exercised, the option is covered. Many people using this strategy believe they don’t have to worry about the complex tax rules that apply to straddles — and many of them are wrong.
Definition of straddle
Among option traders, the word straddle refers to a specific strategy that has nothing to do with selling covered calls. This is one reason people using a covered call strategy may believe they don’t have to worry about the tax rules for straddles.
Yet the tax law uses the word straddle in a far broader way. In general you have a straddle whenever you hold offsetting positions, which means one position reduces your risk of loss from the other. In a covered call strategy, your long position (the shares of stock) limits the loss you would suffer on the short position (the option you sold) if the stock price soars. As a result, you’re within the general definition of straddle as that term is used in the tax law even though you aren’t using a strategy that’s considered a straddle within the lexicon of option traders.
Our book on capital gains
Covered call exception
The tax law provides an exception to the straddle rules for covered calls, and this is a second reason many people are mistaken in believing they can ignore those rules when using a covered call strategy. The exception is available only for options that satisfy specific requirements. For example, the call option must have more than 30 days until expiration at the time you sell. If your strategy involves selling options that are set to expire within 30 days, you don’t qualify for the exception, so you’re creating straddles for tax purposes. Likewise, if the option you’re selling is considered deep in the money according to a complicated definition, your covered call doesn’t qualify. What’s more, the long position has to be shares of stock. If your long position is something else — a LEAP, for example — you aren’t selling qualified covered calls. And finally, there’s a special rule that can disallow certain year-end losses (requiring you to take them in the following year) even if you do meet all the requirements for qualified covered calls.
In short, if you’re using a covered call strategy you’d better bone up on the straddle rules. Chances are that they’ll affect your tax reporting one way or another.
Related
- Capital Gains, Minimal Taxes (our book)
- Capital Gains (free online guide)
Tags: covered calls, feature, straddles
