30.11 Puts and Calls and Index Options

You may buy options to buy and sell stock. On the stock exchange, these options are named calls and puts. A call gives you the right to require the seller of the option to sell you stock during the option period at a fixed price, called the exercise or strike price. A put gives you the right to require the seller of the option to buy stock you own at a fixed price during the option period. See the chart on the preceding page for an explanation of different option terms.

The option price depends on the value of the stock, the length of the option period, the volatility of the stock, and the demand and supply for options for the particular stock.

Puts may be treated as short sales. Be careful in using puts when you own stock covered by the put. If you have held the stock short term, the purchase of the put is a short sale. The exercise or expiration of the put will then be treated as the closing of the short sale. Short-sale rules, however, do not apply (1) when you hold stock long term, and (2) when you buy a put and the related stock on the same day and identify the stock with the put (30.5).

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image Planning Reminder
Speculate With Puts and Calls
Puts and calls allow you to speculate at the expense of a small investment—a call, for expected price rises, and a put, for expected price declines. They may also be used to protect paper profits or fix the amount of your losses on securities you own.
You do not have to exercise a put or call to realize your profit. You may sell the option to realize your profit. If you exercise a call, the cost of the call is added to the cost of the stock purchased. If you exercise a put, you reduce the selling price of stock sold by the cost of the put. If you do not exercise a call or put, you realize a capital loss.
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Buyers of options.

If you buy an option, the tax treatment of your investment in the option depends on what you do with it.

1. If you sell it, you realize short-term or long-term capital gain or loss, depending upon how long you held the option.
2. If you allow the option to expire without exercise, you incur a short-term or long-term capital loss, depending on the holding period of the option. The expiration date is treated as the date the option is disposed of.
3. If you exercise a call and buy the stock, you add the cost of the call to the basis of the stock. If you exercise a put, the cost of the put reduces your amount realized when figuring gain or loss on the sale of the underlying stock.

Grantors of options.

If you write an option through the exchange, you do not treat the premium received for writing the option as income at the time of receipt. You do not realize profit or loss until the option transaction is closed. This may occur when the option expires or is exercised or when you “buy in” on the exchange an option similar to the one you gave to end your obligation to deliver the stock. Here are the rules for these events:

1. If the option is not exercised, you report the premium as short-term capital gain in the year the option expires.
2. If the option is exercised, you add the premium to the sales proceeds of the stock to determine gain or loss on the sale of the stock. Gain or loss is short term or long term depending upon the holding period of the stock.
3. If you “buy in” an equivalent option in a closing transaction, you realize profit or loss for the difference between the premium of the option you sold and the cost of the closing option. The profit or loss is treated as short-term capital gain or loss. However, a loss on a covered call that has a stated price below the stock price may be long-term capital loss if, at the time of the loss, long-term gain would be realized on the sale of the stock. Furthermore, the holding period of such stock is suspended during the period in which the option is open. Finally, year-end losses from covered call options are not deductible, unless the stock is held uncovered for more than 30 days following the date on which the option is closed.

Using a call as leverage.

You expect a stock to appreciate in value but you do not have sufficient capital for a further investment. Instead of investing your limited amount of capital in an outright purchase, you might buy a call covering such stock. With a call, the same amount of capital allows you to speculate in many more shares than you could if you purchased stock outright. If the stock rises in value, your call also increases in value.

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