Option contracts give you the right to buy (via calls) or sell (via puts) a set amount of some underlying asset, such as bonds, stocks or futures, for a fixed price -- the strike price -- on or before the expiration date. A “sell to cover” is an action you can take to rid yourself of a previously purchased option.
Buying an Option
To purchase an option, you must open a brokerage account with a trading level that permits option purchases. You need to pay the option's price, called the “premium,” upfront. The premium plus commission forms the cost basis of the option. When you buy a call, you bet that the price of underlying asset will increase. Puts profit when the asset loses value. At any given time, the price of the option reflects the difference between the asset price and the strike price plus any time value remaining in the option. Time value is the portion of the option price based on the chance that the option will gain intrinsic value before expiration. Time value evaporates completely by the expiration date.
Selling to Cover
You have three ways to dispose of your option. If it loses all its value, you simply let it expire. Otherwise, you can exercise the option and buy or sell the underlying asset, or you can sell the option. The sell an option through “offset” -- you sell an option identical to the one you bought and the two cancel each other. To figure your capital gain or loss, you subtract the cost basis from the sales proceeds. For calls, your sale proceeds are, at minimum, the market value of the asset minus its value at the strike price. For puts, the sales proceeds are the strike value minus the market value. The sale proceeds might exceed these amounts if the option retains any time value.
You report your gain or loss in the year you close an option position by selling to cover, letting the option expire, or disposing of the underlying assets from exercised options. By February 15, your broker will send to the Internal Revenue Service and you copies of IRS Form 1099-B for each of the previous year’s closed option positions, listing the cost basis, the sales proceeds, the commissions and the type of capital gain. Most option trades result in short-term capital gains or losses. However, if you hold the option for over a year before offsetting it, the gain or loss is a long-term one. You transcribe your 1099-B forms onto IRS Form 8949 to calculate your net long-term and short-term capital gains or losses. You then summarize the results on Schedule D of Form 1040.
You pay your marginal bracket -- the tax on the “last dollar” of annual income -- on short-term capital gains. Otherwise, you tax depends on your gross income. In 2013, if it exceeds $400,000 -- or $450,000 for jointly filing married couples -- your capital gains rate is 20 percent. For less lofty incomes, the tax rate is 15 percent if you tax bracket is 25 percent or higher; for lower brackets, the long-term gain is tax-free. Capital losses offset capital gains and up to $3,000 of ordinary income. You can roll forward unused capital losses to future tax years.
As of 2013, individuals with modified adjusted gross income exceeding $200,000 and couples with MAGI above $250,000 are on the hook for a 3.8 percent Medicare surcharge on the lesser of your investment income and the excess of your MAGI above the noted thresholds. For this purpose, "investment income" includes capital gains, interest, dividends, rents, royalties and annuities.
You don’t often see it in option trading because of expirations, but if you repurchase within 30 days the same option you sold to cover, any capital loss on the sale is disallowed under the IRS wash sale rule. Instead, you add the disallowed loss to the cost basis of the repurchased option, which will eventually lower your taxable income when you dispose of the repurchased option. The wash sale rule does not apply to options on futures contracts.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.