Buying Long-Term Calls for Tax Benefit

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In the securities market we know that to buy shares and hold them for over 6 months and make a profit creates a gain taxable at 25 per cent maximum. A profit made in less than 6 months is short-term profit, taxable at the same rate as ordinary income.

The idea in finance today is to make money, true; but how much money net? What's left after tax? For that reason people look for long-term capital gains on which the tax is 25 per cent maximum. A man in the upper income tax bracket may have to pay a tax of 75 per cent or 80 per cent on his ordinary income, but the same amount of long-term capital gain calls for a maximum tax of 25 per cent. Instead of making a dollar, paying 75 cents in tax, and having 25 cents left, one is better off making only 50 cents on a long-term capital-gains basis, paying 12½ cents, and having 37½cents left. Therefore, in any form of capital asset, people look for capital gains opportunities.

In the securities market we know that to buy shares and hold them for over 6 months and make a profit creates a gain taxable at 25 per cent maximum. A profit made in less than 6 months is short-term profit, taxable at the same rate as ordinary income. To buy 100 shares of stock at 50 may result in a gain either long- or short-term—or it may result in a loss. And we don't know how much loss there may be. The Call option for over 6 months—usually for 6 months and 10 days—offers an unlimited possible gain and a limited risk. The risk is limited to the cost of the Call option contract.

The following illustrates this. A man who expects a stock which is selling at 50 to rise, buys a Call option at 50, good for 6 months and 10 days, for $500. Notice the price of $500 for a 6-month option as compared to a 90-day contract for $350. The proportion is about like that—double the length of the contract for about 50 per cent more. If the expected rise materializes and the stock goes to, say, 70 after Mr. Trader has held the contract for over 6 months, he sells his Call contract instead of exercising it. We (and most option-dealers) will always be interested in buying a profitable option; in such instances, we will purchase the Call and exercise it for our own account (50), and sell the stock in the market (70) for our own account. The purchase price which we will pay for the Call will be equal to our net proceeds ($2,000.00), less two regular stock exchange commissions and any applicable tax. In selling such a contract, it has not been necessary to deposit margin with the option-dealer. It is my understanding that, in such transactions, the selling option-holder has ordinarily treated the profit as long-term capital gain on the sale of a contract held for more than six months.

It must be carefully noted, however, that if the holder of the contract exercises his option at 50 and at the same time sells the stock in the market at 70, such a profit is short-term gain by reason of the fact that the stock was held only one day. The holding period of the stock in this case does not date back to the time of the purchase of the option, but only to the time of actual acquisition of the stock.

Compare the two types of trades:

Bought Call at 50 $ 500
Sold Call at 50 with stock 70 2,000
Long-Term Profit $1,500

The tax on this would be 25 per cent or $375, leaving a profit after tax of $1,125.

If the Call had been exercised and the stock sold in the market on the same day, the account would read as follows:

Bought Call at 50 Cost $ 500
Bought stock at 50 by exercise of Call.... 5,000
Sold stock in market at 70 $7,000
Short-Term Gain $1,500

If this man's income put him in the 75 percent bracket, he would pay $1,125 in tax and be left with only $375 net profit after tax. While this procedure is extremely interesting, so is the action taken by the holder of an option that proves unprofitable. If the 6-month option is allowed to lapse, the loss—the cost of the option—is a long-term capital loss. A loss was sustained on a contract which was held over 6 months. However, if the contract which looks as if it will be a loss is sold to another for a nominal sum before the contract is held for 6 months—say 5 months and 20 days, or anything up to 6 months—the loss is a short-term loss.

Bought Call at 50 $500
Sold Call 1
Loss $499

Such short-term losses are valuable to the trader who might have short-term gains, for short-term losses are applicable against short-term profits.

Let us say that a trader has a short-term profit in securities or any capital asset of $500. He buys a Call option of two different stocks for $500 each. One Call is a loss, and he sells the contract in less than 6 months for $1. The other Call is profitable and he sells the contract after 6 months for $2,000 less the cost of his contract-$500. His result is a $1,500 long-term gain on the sale of one contract, and a short-term loss of $499 on the sale of the other contract. The $499 loss practically wipes out the $500 short-term profit and leaves an over-all long-term gain of $1,500, taxable at 25 per cent. Traders in securities would do well to understand this procedure.

As a side thought I would like to tell this story. It happened in November, 1957, after the market had had a severe break. A man with a southern drawl and wearing a big ten-gallon hat, walked into our office and wanted to speak to the "boss." "You know," he said, "I bought a lot of your Calls and I tore them up—lost my money." I thought maybe he was going to pull a gun on me. But my fear quickly vanished when he said, "Don't worry-how lucky it was that I bought Calls instead of stock. If I had bought the stocks way up there I would have gone broke." (The Dow Jones averages declined from 520 in July, 1957, to 420 in October.)

To buy an option, either a Put or a Call, and be wrong, can result in the loss of the cost of the option—that's all. But to buy a stock or sell a stock short and be wrong can cost a lot of money.

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copyright 2005