John M. Hoffman & Associates CPAs
Frequently Asked Tax Questions
Stock Market Call Contracts
These “options” as they are known, are contracts that allow people to exercise some control over certain shares of stock over a certain period of time. These contracts allow people to speculate on a stock for much less money and much less risk than actually owning the stock.
Take a stock like Exxon Mobil (XOM) for example. On 11/26/07, the stock was trading at $85.61 per share. For me to buy 100 shares, I would need $8,561. XOM has been a great stock over time and it has always paid a nice dividend.
Let’s say that I think that the stock is really going to the moon over the next six months, and I want to take a chance and profit on the XOM prospects. Unfortunately I don’t have lots of money and in fact I do not have $8,561 plus commission to buy 100 shares of XOM.
If I am a real risk taker, I could buy an option that lets me profit, if XOM really does take off over the next six months. I look on line and find that I can buy a contact for 100 shares of XOM allowing me to buy 100 shares of XOM at a price of $90 each, anytime between now and the third Friday in April of 2008 for $5.60 per underlying share, or $560 for the contract.
If I purchase this contract, known as an April 2008 XOM 90 call, I have the right anytime between today and April 19, 2008, to have those 100 shares for $90 each, no matter how high they might be. If I don’t exercise that contact before April 19, 2008, the contract expires and becomes worthless. You may wonder why I am buying a contract for the right to purchase the stock at $90 when I can not afford it at $85.61?
Good question. My thought is that someone else will buy my contract from me, and that is how I will make my profit. Why would my contract go up in value? If XOM goes to $110 per share, the profit per share is $20 or $2,000 for the contract (this would be the amount that the contract is “in the money”).
If that happened tomorrow, someone would pay me more than $20 per share or $2,000 per contract because not only did they have the right to cash that in the next day for that “in the money” amount, they got to sit and watch and see if it made more during what is left of the time on the contract. There is a premium associated with being able to control roughly $10,000 worth of stock over the next 5 months.
So, the stock went up $25 overnight and my call contract went from $5.60 to $25.60 overnight. Please note that the stock and the call contract generally go up and down in the same direction, not always at the same dollar amount. I sell me contract for $2,560 and profit $2,000.
How is this transaction taxed?
This transaction is taxed as a short term capital gain (see capital gains and losses).
What happens if, instead, I sit and watch and on April 19, 2008 the stock is still at $85.60 and I let the option expire? In that case, I have a short term capital loss in tax year 2008, with a sale for zero on April 18, 2008 and a buy for $560 on November 26, 2007.
What happens if instead, I do have the money and on February 8, 2008, I exercise the option, paying $90 per share (I exercised early as the stock was going ex dividend and I wanted to be paid that nice dividend), and I now sit and hold my 100 shares of XOM. What happens is that I effectively paid $95.60 per share for my XOM stock. Please note that for capital gain holding period definition, my holding period for these XOM shares began the day after the option was exercised.
So, as you can see, if that stock is really going to shoot up, I can make a lot of money by purchasing the call option contracts. Don’t get too excited, most call option contracts end up expiring worthless.
The other thing to understand is that I purchased that call contract from another investor, likely an investor who actually owned some XOM stock. You may wonder why that person would want to sell me that contract and how that person went about it. That person, perhaps wanted to be on the other side of this “bet”, thinking that the stock was not going to go up dramatically, and willing to sell for that premium the upside of the stock while holding the downside risk of the stock. This person offered to sell this contract on the same market that I offered to buy it.
How would this transaction be treated for the person selling the contract, say I was the person selling?
In the first fact pattern the call contract was sold by me (stockholder) to investor 1 who sold to investor 2. For me (stockholder), there is no consequence (in fact I don’t even know it happened) of this trade of the contract.
In the second example, the option expired and I the selling stockholder got to keep the $560. The transaction looks odd because I sold it in November of 2007 but didn’t close the contract until April of 2008. This is a short term capital gain for tax year 2008. It has a cost of zero on April 19, 2008 and a sale price of $560 on November 26, 2007. Because this transaction can often lapse over tax years, the sale of the call option contracts is not reported to the IRS but it is still a taxable event when the contract is closed.
If instead the stock goes to $110 and while I sit their crying, my shares are called away from my account in February for $90. This is treated just like any other sale of a stock and may be a gain and may be a loss depending on when I purchased the stock.
