Uncle Sam Likes Index Option Spreads

As an option trader, if you don't consider taxation on gains, you probably think you won't have any profits to tax. In which case, you should be thinking twice about trading. But for those of you who know that you're the real thing, listen up.

Brad Griffin, a CPA and a fixture at Index Spread Options Trader talks about options, taxation and the unique status held by index option spreads. First of all, Brad explains that short-term gains from most types of stock and option investing are taxed as ordinary income. If you are in the 31% income bracket, you will pay 31% of your profits as short-term gains. For example, if you have a great short term trade with a profit of $2,000, you pay about $600 of the profits to the Uncle. If you have a losing trade, Uncle feels bad, but you're on your own, baby. Nice partnership. Uncle rewards a trader's patience because when a position is held for more than 12 months, it is considered as a long-term trade and any gains on stock and option investments are normally taxed at 15%. Moreover, if your tax bracket is below 25% then long term gains are taxed only 5%. Uncle is a compassionate fellow but probably wants to know why you have enough money to invest when you're in that low tax bracket.

Mr. Griffin goes on to explain that there is some good news because the gains from stock index options trades are taxed differently than gains on regular stock options and stocks. According to Brad, gains on stock index option spreads are considered ITC Section 1256 contracts. This means any gains made on these trades are taxed under a 60/40 rule: gains are treated as 60% long-term capital gain income and 40% short-term capital gain income (ordinary income)- regardless of how long the investment was held. At the end of his article, Brad reminds us to not trust what he says but do your own due diligence; always good advice.

So what is an index option spread?

As you may know, there are many types of spreads, but the classic definition is: the purchase of one option and the simultaneous sale of a related option, but with different strike prices and/or expiration dates. Index options are traded just like other options with the exception of more favorable taxation. An index is a number which tracks a specific market. For example, some of the markets tracked by an index are:

• NASDQ 100 Index (qqqq)
• NASDAQ (NDX)
• Dax Industrial Index (DJX)
• Dow Jones 30 Index
• S&P 500 Index (SPX)

An example of buying an SPX spread would be the following.

You think that the price of the SPX will rise within a certain time period. You would purchase an SPX call with a certain strike price and expiration month and simultaneously sell an SPX call for the same expiration date but with a different strike price. This is called a "bull spread". By selling (writing) a call, you receive a premium which helps reduce the overall cost of the position versus buying just a straight call. Thus, the spread puts less money at risk when assuming a long position. The same concept works for puts when in a down market.

To learn more about options, take advantage of optrev.com to give you the education on everything you need to know about options-from basic to master.