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Record Keeping

The ordinary stock or fund investor definitely has a need to maintain good records.  There is no substitute for knowing your overall tax situation at any time during a calendar year, especially if you pay estimated taxes.  One thing I do is keep an electronic (PDF) copy, with backups, of my trade confirmations, monthly statements and each year’s 1099 form from all my brokers. This is especially true for my option broker.

However, just preserving the raw data will not be much help if you don’t pay attention to the status of your investments and your account profit and loss results, including cash flow.  There are basically two general approaches for doing this, software especially adapted for investment tracking and spreadsheets.

With respect to portfolio tracking software, BetterInvesting™ Portfolio Manager, which is also available outside of BI by the name Investment Account Manager 2.0, are well suited for tracking, organizing and reporting on your trades, but they both handle options as well.  The two programs are made available by Quant IX Software, aka the Willms brothers.  There’s also Quicken and Money, both of which can handle ordinary investment transaction data, but neither of which can correctly handle option trades.  There’s a work-around, but it’s simply not worth the time and effort.  My advice is to use either BI Portfolio Manager or IAM 2.0 or a spreadsheet if you want to go the do-it-yourself route.  You can get information on BIPM at the BI website and find out more about IAM 2.0 at http://www.quantixsoftware.com/.

The important thing to note here is that you’ve got to keep good records and preserve them.  Further, those records need to be current and accurate and tied to tax requirements by the program you use or by yourself.  Also note that option related records pile up a whole lot faster than you realize so staying current on this effort is not as straightforward as it initially appears.  Like Nike says, “Just do it!”

Keep in mind that when you write a covered call or a put that’s later exercised, you have two transactions arising from such trades, not just a single buy or sell as when a stock or fund is bought for its growth potential or sold after that potential has been realized or a loss is accepted.  You also have dividends and account interest to track in an option account, as in a standard growth account that doesn’t include options, while also being mindful of some option tax quirks. 

Next, we’ll take a look at tax considerations for option traders.

Saul…

Taxes (2)

As with other types of investments, short-term capital gains from options (gains from capital assets owned for one year or less) are subject to tax at ordinary rates, currently up to 35%. A LEAP, if owned for more than a year, would qualify for long term capital gain treatment.  Absent further legislation, a marginal tax rate of up to 39.6% will again apply for tax years beginning after December 31, 2010.

A “maximum” tax rate of 15% applies to long term capital gains (i.e., gains from assets with a holding period of more than one year). The 15% rate applies to long-term capital gains from most investments in stock and securities, but there are exceptions. This rate is scheduled to increase to 20% for years beginning after December 31, 2010.  

Watch out for the Alternative Maximum Tax or AMT. 

Also be mindful of the Wash Sale rule that prohibits certain transactions where taxpayers sell stock or securities (including options) at a loss and reacquire “substantially identical” stock or securities (or options to acquire substantially identical stock or securities) within a 30-day period before or after the sale occurs.

When the wash sale rule applies, the loss is disallowed and the basis of the new property is deemed to be the basis of the original property, increased or decreased, as the case may be, by the difference between the cost of the new property and the price at which the old property was sold. The holding period of the original property is added to the holding period of the newly acquired property.

Acquiring an option to sell (a “put”) is treated as a short sale for purposes of the short sale rules, but a “married put” has been exempted from these rules. However, a married put appears to be subject to the tax straddle rules, discussed on page 16 of the booklet.  In other words, be aware that certain options, not covered calls, can require the application of tax treatment you might not expect.  If you plan to implement “married puts,” this is a requirement you’ll need to check on.

The booklet discussion of One-Sided Equity Option Positions, beginning on page 14 of the booklet should be read by all option traders, including those who write covered calls. 

A premium received for writing a call is not included in income at the time of receipt, but is held in suspense until the call expires or the writer either sells the underlying stock as a result of the assignment of the call or closes out the option by entering into a closing transaction. If the call expires, the premium is taken into income as short-term capital gain regardless of the length of time the call is outstanding.

This also means that if you wrote a 3 month covered call in November of 2008 that expired in February 2009, the premium does not have to recognized for tax purposes until February.  While you can elect to pay taxes on the premium in 2008, waiting until 2009 allows you to enjoy use of the premium in the interim.  However, please make sure you keep records of such transactions and tax obligations so you pay the tax no later than its due date.

Similarly, gain or loss on the termination of the option through a closing transaction is a short term capital gain or loss, regardless of the length of time the call is outstanding. However, if a call is assigned, the strike price plus the premium received becomes the sale price of the stock in determining gain or loss. The resulting gain or loss depends upon the holding period and the basis of the underlying property used to make the delivery to satisfy the assignment. If the stock delivered has a holding period greater than one year (taking into account the tax straddle rules), the gain or loss would be long-term.

Here’s one of those unexpected tax quirks I mentioned in the prior workshop segment on taxes.  Writing an at-the-money (strike price of call equals the stock price used in determining the lowest acceptable strike) or an out-of-the-money (above the-market) qualified covered call allows the holding period of the underlying stock to continue.

However, an in-the-money qualified covered call suspends the holding period of the stock during the time of the option’s existence. For an individual or investment club selling a call on stock already owned, assume it was purchased 10 months earlier, this means that the holding period is suspended if the qualified call sold is in-the-money.  If the call expires and the stock is sold 2 months later, even though the total holding period is over 12 months, the stock sale will not qualify for long term capital gain treatment because of the suspension. 

The foregoing has been a quick review of highlights applicable to option traders. Read the tax materials for a complete explanation.  I strongly recommend that all option traders, especially beginning option traders, have at least that portion of their tax returns dealing with options, prepared or reviewed by a professional tax preparer.

Next, I’ll do a quick summary of the workshop by way of my top ten option rules to live.

Saul…

Hi Saul:

Thanks for mentioning both BI Portfolio Manager as well as Investment Account Manager for the record keeping aspects of option trading.  Both progams do handle a wide range of option transactions, such as:

• opening buys
• closing sales
• opening sales
• closing buys
• expired
• assigned
• exercised

Both programs will properly handle the general tax aspects of these transactions, accounting for premiums recieved, gains/losses on expired options, and cost basis adjustments to underlying issues for assigned or exercised.

Portfolio Manager and Investment Account Manager (IAM) are near clones, with the difference being IAM allows the use of a StockCentral subscription as the source for stock data downloads; Portfolio Manager uses the BI data feed.

Great discussion on options!  I'm sure everyone found your topics very educational.  See you at InvestEd 2009....

Regards,

Matt

As a novice, I'm interested in most things & I believe options trading can be an important addition to my portfolio.  The education you propose would be greatly appreciated.

I've watched the Friday night show and it makes no sense to me, I'm an optomist so I will keep watching; your opinion of Dr. J...................................inspiring.   You confirmed what I thought.