Trading Indexes and Index Options
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 right 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 2018 175 Call option represents the right to purchase on or before January 2018 expiration, 100 shares of Apple Corp stock for $175 per share, or a total of $17,500. 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.
Popular broad-based indexes:
DJX - Dow Jones
SPX - S&P 500
RUT - Russell 2000
OEX - S&P 100 American
XEO - S&P 100 European
Do not confuse these with corresponding ETFs:
DJX ≠ DIA (Diamonds)
SPX ≠ SPY (SPDR)
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.
These are the original opening transactions
These are the positions at year-end, when they are "marked to market"
This is the gain or loss on the positions as of year-end after being marked to market; Both the SPX and RUT are UP at year-end
These are the detail calculations for Form 6781; This may or may not be attached to your tax return - I typically do.
Our example uses the SPX and RUT as the indexes traded.
BTO - Buy to Open
STO - Sell to Open
BTC - Buy to Close
STC - Sell to Close
If the Indexes are only in one account, only one account needs to be listed on Form 6781