In several locations on this website, the taxation of indexes has been mentioned (see Mark to Market example specifically and several of the Presentations).

To the left is a listing of some of the more popular broad-based indexes.

Although an index - and options on the index - can be traded, they actually represent “an imaginary portfolio of securities representing a particular market or a portion of” that market.  Investopedia > Dictionary > Index

Index options are differentiated from equity options.  The underlying instrument of an equity-based option is the specific stock of the option.  For example, 1 AAPL Jan 2012 400 Call option represents the right to purchase on or before January 2012 expiration, 100 shares of Apple Corp stock for $400 per share, or a total of $40,000.  An index-based option relates to the intangible value of a particular index which can be calculated based on price or market capitalization or some other measure.  That value is not settled in an equity position, ie, 100 shares of Apple Corp stock, but the cash value of the index times a multiplier, usually $100.  Therefore, they are cash-settled rather than stock-settled.

So why is this important?

Index options are taxed differently than stock and ETFs and reported differently than what has been described previously - either Schedule D for investors and traders and Form 4797 for MTM traders.

Index options (nonequity options) are reported as Section 1256 Contracts on Form 6781.  An index option held at the end of the year must be marked to market - just like a MTM trader - as of the last business day of the year and gain or loss recognized based on a deemed closing* transaction.

The actual language of IRC Sec 1256 states:

(a) General rule.  For purposes of this subtitle -

(1) each section 1256 contract held by the taxpayer at the close of the taxable year shall be treated as sold for its fair market value on the last business day of such taxable year (and any gain or loss shall be taken into account for the taxable year)  [emphasis mine]

The statute goes on to say that any gain or loss with respect to a section 1256 contract is treated:

(1)  40% short-term, and

(2)  60% long-term

Further, any net section 1256 loss may be carried back three years.

How are the indexes taxed?

Apparently, according to the IRC Sec 1256, only the options on the indexes are considered 1256 contracts and the indexes themselves are not.  Also, a MTM trader would not be considered a dealer in equity options since the requirement for this classification would be that the options dealer be designated as a market maker in listed options.  Thus, even though a MTM election places the trader into using the same accounting method as a dealer in securities, the MTM trader is not considered a dealer in securities.

* See discussion of “sale” vs “closing” transactions pursuant to IRC Sec 475

Popular broad-based indexes:

DJX - Dow Jones

SPX - S&P 500

RUT - Russell 2000

OEX - S&P 100 Amer

XEO - S&P 100 Eur

Do not confuse these with corresponding ETFs:

DJX ≠ DIA (Diamonds)

SPX ≠ SPY (SPDR)

Example:

•  BTO 3 SPX Jan 11 1270 Puts for 20 on 10/13/2010

•  STO 3 SPX Jan 11 1275 Puts for 22 on 10/13/2010

•  BTO 10 DJX Mar 11 123 Calls for 5 on 10/30/2010

•  STO 10 DJX Mar 11 125 Calls for 4 on 10/30/2010

These options are held as of the last business day in 2010 and their respective fair market values are as follows

•  SPX Jan 11 1270 Put = 12

•  SPX Jan 11 1275 Put = 14.5

•  DJX Mar 11 123 Call = 7

•  DJX Mar 11 125 Call = 5

Attach to tax return

View the above example as reflected on a tax return

Definitions

BTO = Buy to Open

STO = Sell to Open

BTC = Buy to Close

STC = Sell to Close