Options are not straightforward tax instruments. A simple covered call can inadvertently terminate the long-term holding period on the underlying stock. An index option that would normally generate short-term gains instead gets blended at a 60/40 long-term/short-term rate under §1256. A protective put creates a straddle that suspends the holding period of the stock it protects. The tax rules governing options are among the most technical in the Code, and individual investors who trade options frequently - or who use them for hedging - routinely make tax errors that cost real money.
Buying an option (long call or put): No tax event at purchase. If the option expires worthless, a capital loss equal to the premium paid is recognized on the expiration date. If the option is exercised (call), the premium is added to the cost basis of the stock purchased. If the option is sold before expiration, the gain or loss is short-term or long-term based on the holding period of the option itself.
Selling an option (short call or put): No tax event at sale (receipt of premium). If the option expires worthless, the premium received is short-term capital gain. If the option is exercised against the writer, the premium is included in the sale price (for calls) or reduces the cost basis (for puts) of the stock transacted.
Holding period for options: Options held more than one year generate long-term gain or loss. Most individual option trades are short-term because most options have less than one year to expiration.
Writing a covered call - selling a call option against stock you own - can suspend or terminate the long-term holding period of the underlying stock. Under IRC §246(c) and the qualified covered call rules, if you sell an "in the money" call against stock that has not yet reached long-term holding period status, the holding period of the stock is suspended for the duration of the call. If the stock was already long-term but the call is deep in the money, it may cause the stock to lose its long-term status entirely.
The qualified covered call exception: a covered call that meets the definition of a "qualified covered call option" - generally a call that is not deep in the money relative to the stock's current price, written on exchange-listed stock, with certain minimum time to expiration - does not suspend or terminate the holding period of the underlying stock. Understanding when a covered call is "qualified" requires checking the option's strike price against the IRS tables for the stock's price range.
Options on broad-based stock indices (S&P 500, Russell 2000, Nasdaq 100 options traded on regulated exchanges) are §1256 contracts. They are marked to market at December 31 each year and taxed at the blended 60% long-term / 40% short-term rate regardless of actual holding period. This is a significant benefit for active index option traders: even a one-day trade generates 60% long-term capital gain treatment. The blended rate produces an effective maximum rate of approximately 26.8% versus 37% for pure short-term gains. Options on individual stocks (SPY is an ETF, not an index - be careful) and equity options generally are NOT §1256 contracts.
A straddle under IRC §1092 is a combination of offsetting positions - typically owning a stock and buying a put on the same stock (a protective put), or buying both a call and a put on the same stock. The straddle rules: (1) losses on one leg of a straddle are deferred to the extent of unrecognized gain in the other leg; (2) the holding period of each position does not begin until the straddle is closed; (3) interest and carrying charges allocable to straddle positions are capitalized rather than deducted currently. The practical effect: a protective put that is sold at a loss when the stock has appreciated cannot generate a deductible loss in the current year.