Straddles
Tax Straddles are basically two offsetting positions, one with gain and one with loss that offsets the gain. Essentially, IRS does not want the trader to be able to recognize the loss in one tax year while deferring the gain to a subsequent year. Therefore, the tax straddle rules were enacted to defer the loss into a gain recognition year.
The tax straddle rules present some of the most complex rules and reporting guidelines in the Internal Revenue Code & Regulations. The manner in which they are written seems to make any loss on one option position, while holding another stock or option position, non-deductible. I do not believe that is the case. As stated above, the basic premise of tax straddles is a timing issue of when realized losses can be recognized for tax purposes.
Tax Court cases also state that if there is no profit motive when entering into a tax straddle, the losses will most probably be denied until the entire position is closed.
Why is this important?
It determines and/or limits the amount of LOSS that may be recognized on a stock and/or option transaction.
When Straddles are not Straddles ...
Most option traders know that a straddle is defined as a two-option strategy where the trader has both a long call and a long put, not knowing exactly which direction the underlying stock will move but betting that it will move in one direction ... fast and hopefully far!!
Well, the IRS defines a straddle another way.
The IRS defines a straddle as the holding of personal property in such a way that the position - the offsetting position - substantially reduces the risk of loss. (IRC Sec 1092) For purposes of the holding of stock and an offsetting option position - a protective put, for instance - stock is considered personal property whereas it is typically considered a capital asset in the hands of an investor or a trader, but not a dealer. The term "substantially" is never defined in the Internal Revenue Code or Regulations.
This rule does not apply to regulated futures contracts, non-equity options, ie, an option on the SPX, or dealers. It also does not apply to those who have made a mark-to-market election.
These rules are very complicated and can apply in unexpected situations.
In fact, a straddle may be created with the options of another security, unlike the wash sale rules - a type of straddle - which generally requires the same underlying stock.
Straddle Examples
If applicable, losses on positions comprising the straddle may be deferred until gains are recognized on the remaining position comprising the straddle.
Example 1: A trader owns 100 shares of AAPL purchased at $120 per share. AAPL is currently selling at $150 per share and the trader purchases a protective put at 145. The expiration of the put unexercised will not be considered a capital loss because the put is above the basis of the underlying stock and thus, unrecognized gain. The loss is deferred and may be taken when the gain on the shares is recognized.
Example 2: A trader owns 1000 shares of TEVA at $15 per share. TEVA is currently priced at $12 per share. The trader purchases a protective put for $1 to guard against further losses at a strike price of 10 that expires in July. TEVA does not get to $10 per share during the term of the option and the puts expire worthless. The trader recognizes a capital loss of $1000 ($1 x 1000 shs)
The determination of whether the loss is deferred is made at the end of the year.
Example 3: Assume the same facts as in Example 2, except now TEVA recovers to $20 by year-end. The loss is deferred on the expired protective put to the extent of the unrecognized gain in TEVA as of year-end. The unrecognized gain in TEVA is $4,000 ($20 - $16 x 1000 shs) and the cost of the protective put was $1,000, therefore, all the loss is deferred.
Whether the recognized loss is long-term or short-term is based upon how long the trader held the stock (holding period) before purchasing the protective put.
So, specifically with regard to Example 2, if the trader had held TEVA for more than one year, the capital loss would be long-term, otherwise it would be short-term. If some shares were held long-term and others short-term, presumably the recognized loss would bear that same percentage. For instance, if 700 shares were long-term and 300 shares were short-term, the trader would recognize $700 long-term capital loss and $300 short-term capital loss.
IRS Example - Pub 550
"On July 9, 2022, you entered into a straddle - two offsetting positions. On December 12, 2022, you closed one position of the straddle at a loss of $15,000. On December 31, 2022, the end of your tax year, you have an unrecognized gain of $12,750 in the offsetting open position. On your 2022 return, your deductible loss on the position you closed is limited to $2,250 ($15,000 − $12,750). You must carry forward the unused loss of $12,750." [Italics mine]
So some loss is deductible ($2,250) - the amount that exceeds the unrecognized gain in the open position. The remaining loss is deductible against the gain when recognized.
Married Puts
For a “married put” to truly be “married”, the stock and the put must be acquired on the same day and the stock must be identified as the stock that will be delivered upon exercise of the put.
If the put expires worthless, and the stock has decreased in price, but not to the put strike, the trader presumably will not be able to recognize the loss on the put expiration but will have to add the cost of the put to the adjusted cost basis of the stock.
Which then begs the question, what if a subsequent put is purchased as a substitute for the original put? In my opinion, the substitute put no longer meets the “married put” requirement of being purchased on the same day as the stock. Therefore, subject to the offsetting position rules above, it would qualify for capital loss treatment.
A married put is also exempt from the short sale rules.
Qualified Covered Calls
Remember that the IRS defines a straddle as the holding of personal property in such a way that risk of loss is substantially reduced. Also, for offsetting position purposes, stock and options are considered personal property. Thus, losses are deferred on straddle positions.
A qualified covered call is not subject to these loss deferral rules.
How can a covered call be subject to these rules anyway? Isn’t that an income strategy? It is an income strategy but the covered call can be sold so deep in the money (DITM) that it substantially reduces the risk of loss.
So, what constitutes a “qualified covered call”? A qualified covered call generally must:
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Be traded on a national securities exchange,
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Be written more than 30 days before its expiration,
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Not be a DITM option as defined below,
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Be sold by a non-dealer, and
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Be capital gain or loss by the trader.
What is the definition of deep in-the-money option? It is an option with a strike price lower than the “lowest qualified benchmark” which is generally the option offered at one strike below the current stock price. There are special rules for various stock prices and option expirations according to IRC Sec 1092(c)(4)(D). The code also defines the applicable stock price as opposed to the current stock price.
In my opinion, this definition needs to be revised given the proliferation of $1 strikes and weekly option expirations, in addition to, increased market volatility.
So what does all this mean? If you are employing a covered call strategy, your covered calls should be either at-the-money (ATM) or out-of-the-money (OTM) in order to avoid the loss deferral issues associated with selling calls DITM and thus subject to the straddle rules.
Deep In The Money Example
Option chain from thinkorswim by TD Ameritrade
So, a DITM option strategy in this instance guarantees a loss on the stock and gain on the option. So where's the hitch? Basically, a DITM covered call strategy may not be the best tactic from either an IRS or an investment return perspective.
Remember, if you are subject to the straddle rules, you are subject to loss deferral instead of being able to use the loss to shelter gains. Another reason to elect mark-to-market!!
Collars
The definition of a collar trade is simply a covered call with a protective put - see Risk Profiles. Again, the IRS feels the need to define this further in an attempt to properly match gains and losses.
Even though a trader may write a qualified covered call on a stock which would otherwise qualify as an anti-straddle position, when the trader adds a protective put to the trade, it is defined as a straddle by IRS and any loss on any portion of the position is subject to loss deferral to the extent of the unrecognized gain on the entire position.
This seems quite onerous and virtually impossible to report correctly, especially if day trading or executing a number of trades where assignment is possible.
Mixed Straddles
What in the world is a "mixed" straddle?
A mixed straddle is two offsetting positions, one of which is a non-Section 1256 contract and the other is a Section 1256 contract. Section 1256 refers to Internal Revenue Code section 1256.
Section 1256 contracts are:
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Regulated futures contracts
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Foreign currency contracts
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Non-equity options - an option whose underlying is not common stock, ie, DJX, SPX, OEX, RUT, VIX
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Dealer equity options - options by dealers on national securities exchanges
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Dealer securities futures contracts
Addressed on this website
Section 1256 contracts are marked to market (FMV) at year-end and tax 60% long-term and 40% short-term. Non-Section 1256 contracts are basically everything else. For instance, a mixed straddle could be comprised of a long position in SPY and a short (offsetting) position in SPX, or possibly OEX (S&P 100 index).
Straddles are complex but mixed straddles are even more complex. Their taxation can depend on the current position - gain or loss - and whether any elections have been made, such as, an election out of the 60/40 mark-to-market rules, or others.
To be honest, if you are reading this and do not understand Section 1256 or non-Section 1256 contracts, you should not be trading them. Their taxation is beyond the scope of the typical investor/trader and if you are a mark-to-market trader, you are not subject to these rules.
Conclusions - Planning
A few observations become readily apparent upon a close look at the rules. It’s always a good idea to understand the rules as completely as possible, and then use the IRS rules against them instead of ignoring them and hope you don’t get audited.
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Remember that options are defined as securities. Each security has an opening trade and a closing trade. You are not taxed on strategies but on each security traded. It seems, therefore, that instead of letting the violating security expire, as that seems to trigger the straddle rules, close the trade. Once closed, no straddle position exists.
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Use alternative strategies to accomplish the same goal. Take a look at the Strategy Comparisons page to see how you could structure a trade that has the same risk but does not use the same instruments. For instance, instead of a Collar trade use a Bull Put.
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If you take a look at the Greeks, most of the value in a DITM option is its intrinsic value. As the above DITM example reflects, at best, the sale of a DITM call, when employing a covered call strategy is close to break-even, assuming the underlying remains above the strike of the option. When commissions are included, there is most likely a small loss.