So what is the difference between:
An “offsetting position,” and
A “spread trade”?
And as a corollary to that, what is the difference between:
Substantial diminution of risk, and
Mitigation of risk?
Believe it or not, the answer to those questions are somewhat straightforward, but can lead to divergent tax positions.
Let’s examine each of these in order.
Offsetting Positions Have Many Monikers
Before we look at individual definitions and examples, let’s take a look at what the Internal Revenue Code says about straddles.
A “straddle” is an offsetting position with respect to personal property (IRC Sec 1092(c)(1)
Further, positions are presumed to be offsetting if (in pertinent part):
(i) the positions are in the same personal property (whether established in such property [same type] or a contract for such property [option]), [Emphasis mine]
(iv) the positions are sold or marketed as offsetting positions (whether or not such positions are called a straddle, spread, butterfly, or any similar name), [Emphasis mine]
(v) the aggregate margin requirement for such positions is lower than the sum of the margin requirements for each such position (if held separately), or
(vi) other factors prescribed by the Secretary. (IRC Sec 1092(c)(3)(A)
However, any presumption established pursuant to subparagraph (A) [the list noted above] may be rebutted. IRC Sec 1092(c)(3)
So, that means each presumption is not to be regarded as “set in stone” but is arguable on it’s merits.
Thus, not all trading positions that mitigate risk are necessarily considered offsetting.
A straddle is an offsetting position, without question.
So when is a straddle typically used? When the trader anticipates a large move in the underlying but does not know which direction.
This would most likely be traded at an earnings event when the direction of the underlying after announcement cannot be predicted.
Therefore, if the underlying makes a big move downward, the long put will increase in price whereas the long call will decrease and vice versa if the underlying makes a significant move upward.
There are several outcomes for this trade:
The winning option is exercised and the stock is further traded (long call) or covered (long put) and the losing option expires worthless
Both options are closed before expiration (STC)
The winning option is exercised and the stock is further traded (long call) or covered (long put) and the losing option is closed (STC)
Let’s look at a couple examples
Long call and long put on AMZN at earnings on 4/28/2017 earnings announcements.
Earnings announcement date: 4/27/2017, After Market Close
4/24/17 - Price 908.21
Long call - Strike price of 907.50 (ITM) expiring 4/28/2017 cost $19.30
Long put - Strike price of 907.50 (OTM) expiring 4/28/2017 cost $18.50
4/28/2017 - Price 924.99
Long call price $23.70; Gain of $4.40
Long put price $0.02; Loss of $18.48
Example 1: Exercise Long Call, allow Long Put to expire, Sell AMZN on 5/1/2017 at $948
Example 2: Close both positions on 4/28/2017
In this example, because the Long Put is only Bid at $0.02, there is really no point in issuing a STC order so we will ignore outcome 3. All examples commissions and fees.
Note that in the above example, three securities were traded but only two are reported. The cost of the Long Call is included in the Exercise price of the underlying (907.50 + 19.30).
There are many trades that may be termed “offsetting positions” and many questions regarding the tax implications of these trades. As you will soon realize, keeping track of these is a formidable task.
Now would be a good time to delve into the question of what is “substantial diminution of risk” which is actually the basis for determining whether a trade position is offsetting.
You will note that the definition of offsetting positions is very similar to that of a straddle found in IRC Sec 1092.
A taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of holding one or more other positions with respect to personal property (whether or not of the same kind) IRC Sec 1092(c)(2)
There are a couple of terms that need exploring:
What is “substantial” diminution of risk?
What is “whether or not of the same kind” mean?
Substantial is defined as “ample or considerable amount, quantity or size”
Therefore, risk has to be virtually eliminated in order for there to be a substantial decrease in the amount of risk undertaken during a particular trade.
This will be examined more below in the Spread Trades discussion.
So, for there to be an elimination or considerable amount of risk decrease, one position would have to decrease in price while the other (offsetting) position increases in price at virtually the same rate.
Therefore, many “mainline” trades can be considered offsetting positions!!!
Straddles/strangles (Long or short)
Covered calls (Long stock with short call)
Married puts (Long stock with long put)
Spread trades (see below)
And the list goes on …
As you can see, virtually every trade where the trader attempts to limit risk can be considered an offsetting position.
In my opinion the terms “offsetting position” and the IRC use of the term “straddle” are catch-all phrases for the limitation of the recognition of loss when two or more positions are used to mitigate trade risk.
Substantial Diminution of Risk
Of The Same Kind
In the context of trading this means that an offsetting position is with the same underlying or options on the same underlying. For instance:
A long call on AAPL and a long put on AAPL
Long stock on AAPL and a short call on AAPL (covered call)
Long stock on AAPL and a long put on AAPL (married put) - but see exceptions below.
Not Of The Same Kind
In my opinion this is the unreasonable position that an underlying can be offset by a similar underlying. For instance:
Long stock on AAPL and a long put on XLK which contains (as of 7/17/2015) 17.9% AAPL shares
Long call on AAPL and long put on XLK
Note that a covered call cannot be constructed without being “naked” XLK.
If you trade options you know what spread trades are.
These are the most common:
If you are unfamiliar with these types of trades, please refer to the Options Risk Profiles page.
Most people who trade options trade some form of a “spread trade” in order to minimize the risk of, at least, theoretically unlimited loss. For instance, a naked short call has theoretically unlimited risk. Although from a practical standpoint, when was the last time you saw a stock or ETF go to infinity?
Even though a position doesn’t have “unlimited” risk, a trader could lose several thousand dollars in one day if the trade goes against them … and I know this from personal experience!
So the question becomes …
IRS prevents the trader, investor or regular taxpayer, for that matter, from being able to recognize loss currently and defer gain into the future.
Therefore, the consequences of holding an offsetting position are as follows:
The Wash Sale rules apply to realized losses
The holding period is suspended during the period the offsetting positions are held
As of year-end, no deduction for loss is allowable to the extent of the unrecognized gain (only loss that exceeds the amount of gain realized but not recognized - this is very technical and complicated when dealing with options), and
Interest (margin) expense is required to be capitalized during the period of offset
Most of these rules were developed before the trading of options became as popular as it is today. However, the legislative writers included options in their definition of offsetting positions, both as individual tradable securities and as vehicles for stock ownership, ie, a short put option with a 30-day or less expiration is equivalent to the purchase of the stock, if there is a substantial likelihood that the option will be exercised.
Married puts - if the long put is acquired on the same day as the underlying and the underlying is identified as the deliverable underlying if the put is exercised
Qualified Covered Calls - if the short call has more than 30 days to expiration (DTE) and the strike price is NOT less than the first available strike price BELOW the closing price of the underlying on the day BEFORE the option is sold, for example:
AAPL closing price on 10/20/2015 was $156.25. Therefore, a qualified covered call must have a strike price equal to or greater than $155 and an expiration no earlier than 7/18/2015
With the advent of weekly expirations and higher overall volatility, this requirement may put a severe constraint on some trading strategies.
By attempting to mitigate one’s risk, does the trader paint himself into a corner and create an “offsetting position”?
So, how did this very technical topic get started anyway?
I received an email from an investor who had read some IRS publications and interpreted their position that a spread trade was an offsetting position and that the strategy was taxed as opposed to the individual securities comprising the offsetting positions/strategy.
It is actually a pretty good question given the confusion presented by the IRS publications. But note my comment below.
If you have spent any time researching option positions, you will note that many “strategies” can be constructed with many strikes and expirations.
So if strategies are taxed and an option position within the strategy is closed before year-end, is it taxed? Is it even reported? The answer is “Yes” it is both taxed, as discussed above, and it is reported in the tax year the transaction is completed.
For instance, an investor/trader buys 5 puts in Sep 2014 that expire in Feb 2015. At the same time 5 puts are sold at strikes below the long puts that expire each month up to the expiration of the last long put.
If strategies are taxed, essentially the above “strategy” would not be taxed or reported until 2016 on the 2015 tax return.
It is arguably an offsetting position since the five short puts will move in the opposite direction - from a price perspective - than will the five long puts.
So if the price of the underlying security in the above example were to increase and three of the short puts expire worthless, is that reported in 2015 or 2016?
Each option is a security (IRC Sec 1091(a) and as such is discrete in its character. The three short option transactions are complete - there has been a sell to open and a buy to close in the form of an expiration - so all the elements are present to determine gain or loss.
What about the loss on the five long puts? Those positions are not closed as of year-end and no gain or loss is reported.
If one takes the position that options are securities (and they are - see above), each option is taxed discretely, just like stock.
An investor/trader can be long and short stock at the same time and that is considered an offsetting position. But if either long or short position is closed, it is taxed in the year in which it is closed.
The same is true for options!!