Stock options permit the investor to magnify the change in stock price during a specified, usually short, period of time. In exchange for the right to control large amounts of stock, the option holder assumes the risk that if the expected volatility does not materialize, the option will expire worthless. Since every stock option may eventually be exercised, an actual stockholder must normally exist to grant stock options, in exchange for a consideration termed the premium.

An option is, therefore, nothing more than a contract between the owner of the stock (i.e., the writer), and the purchaser, in which the purchaser is granted the right to buy or sell a specified amount of stock at a predetermined exercise or strike price at a future date, termed the expiration date. A “call” is defined as a right to purchase 100 shares of stock from the option writer at the expiration date; a “put” grants the holder a similar right to sell 100 shares of the underlying stock to the writer at the strike price on the expiration date.

Assume, for example, the owner of 10,000 shares of IBM, which is currently trading at $42, wishes to write calls on the stock as a method of increasing its effective yield. Another investor, who believes that IBM will make a sharp upward move in the near future, purchases 10 calls at a strike price of $45 and an expiration date of November, for a premium of $1,000. By January, IBM has indeed risen to $47 and, nearing the expiration of his options, the investor sells the options on the open market for $2,000. Of course, the investor might instead have decided to exercise his right to purchase the underlying shares at the expiration date for $45,000, in which case he would own 1,000 shares of IBM.

If the option itself is sold prior to expiration, taxable gain is simply the difference between the premium paid for the option and the proceeds of the sale, or $1,000. Since the options here were held for only three months, capital gain will be short-term. Alternatively, if the option is exercised at the expiration date, no taxable event will occur until the underlying stock is eventually sold. The holding period for determining eventual gain or loss would be determined by reference to the date the option to purchase the IBM was exercised. Moreover, the $1,000 premium paid for the option is not deductible. Rather, it is added to the cost basis of the stock purchased in determining eventual gain or loss.

The tax consequences to writer depend upon whether the calls are exercised or whether they lapse unexercised. In the latter case, the premium received by the writer is held in a deferred account until the option expires, at which time they are recognized as short-term capital gain. If, as here, the call is exercised, the amount realized on the sale is the sum of the premium initially received plus the exercise proceeds, less commissions. If the IBM were originally purchased for $40,000 in 1991, the writer would report a long-term capital gain of $6,000 (i.e., $45,000 + $1,000 – $40,000), reduced by commissions.