Stock options and taxes? (first time dabbler)

[Nika]

So we finally decided to dabble in stock options short while ago.

We bought 2 stock options for apple -- one for 370 call (paid $3,300) and one for 380 call (paid 3,540).

At this point it looks likely that we may make money. We will have tax consequences. -- both will be held for less than 90 days.
As I understand, we will be taxed on any profit at an ordinary income rate, not capital gains

So my question is -- any difference tax-wise between exercising the option or selling the option?

If I want to buy some apple stock, am I better off exercising the option, than selling excess stock and keeping the difference
or
selling all the stock and than re-buying some shares at the current price?

If I exercised and kept the stock, would that have any tax advantages over the other options?

[jpg7n16]

So my question is -- any difference tax-wise between exercising the option or selling the option?

You first need to decide if you want to keep the shares or not.

Huge difference tax wise. One is a closing taxable transaction, the other isn't.

If you exercise, you will buy 100 shares per contract at the strike price of your option. Your premium will be added to your cost basis for determining gain when you sell the shares later down the road. Exercising is not a taxable event, so no tax would be due at this time. The taxes would only come into play down the line when the stock is sold.

Your 1st option (370 strike) will take $37,000 cash out of pocket to exercise, and the 2nd (380 strike) will take another $38,000. Do you have that available?


If not, the other option you have (irony intended) is to just sell the contract for its current market value.

Proceeds - cost = gain (taxable)

If I want to buy some apple stock, am I better off exercising the option, than selling excess stock and keeping the difference
or
selling all the stock and than re-buying some shares at the current price?

If I exercised and kept the stock, would that have any tax advantages over the other options?

You seem like you're really trying to make this decision based on the tax implications, and not on your goals. That's a bad strategy.

Step 1:
Do you want to own shares of AAPL or not?

If no, then just sell the option when you're ready.

If yes, then step 2:
Do you have enough cash to exercise the option?

If no, then just sell the option when you're ready.

If yes, then step 3: what is the most tax efficient way to own the amount of shares you'd like to own? Do a profit loss comparison between exercising and selling the portion you don't want, and the profit you would make by selling.

If there is a large time premium value left in the option, that may compensate you for the higher tax rate.

[Nika]

Thank you for your detailed answer. It looks like you have done it a few times.

I am a little confused on one point though -- don't brokerage firms float you for few minutes if you want to exercise and sell instantly?

We probably could scrape up 37,000 if having that money available gave us some major advantage over the other alternatives. That is why I wanted to figure out if that effort would be worth it.

I would like to keep to own some AAPL shares, maybe 30.

[Slug]

Wish you'd sold those yesterday.

[Nika]

Wish you'd sold those yesterday.

Well, if I had a crystal ball I would cell each time before a market dive and buy the day before it soars.
But this is not what I am trying to do. Yes, it is unpleasant to see it dive, but chances are good that it will be back to $425 some time between now and January.

[jpg7n16]

I am a little confused on one point though -- don't brokerage firms float you for few minutes if you want to exercise and sell instantly?

Maybe. That may vary by broker and may depend on whether or not you have margin on your account.

But just because you can do something, doesn't necessarily mean you should.

From: https://www.zecco.com/help/options.a...ionbuyingpower

What if I do not have enough buying power to afford the resulting stock position of an exercise or assignment?
Zecco Trading, pursuant to our User Agreement, cannot be exposed to market risk due to positions created in customer accounts and reserves the right to act accordingly. It remains the customer's responsibility to ensure there is sufficient buying power to afford any resulting stock position. If you cannot meet a resulting call, please close your open positions prior to expiration. Zecco Trading reserves the right to liquidate stock or option positions if it deems that sufficient risk to the firm exists.

From: http://www.scottrade.com/documents/a..._Agreement.pdf

3. I agree to immediately deliver any funds or securities required as the result of the exercise or assignment of options contracts in my account. In their sole discretion and without notification to me, Scottrade and its agents are authorized to take any and all steps necessary to protect Scottrade or such agents from loss or damage arising out of any option transaction in my account. This discretion applies regardless of any past action taken or not taken by Scottrade or its agents, and is in no way to be construed as an obligation on the part of Scottrade or its agents to take such action on my behalf. Should Scottrade or its agents deem it necessary for their protection for any reason, or if I die, I hereby authorize Scottrade and its agents to buy, sell or sell short any option or security in my account, depending on my risk level. I agree to reimburse any and all expenses Scottrade or its agents incur in connection with such transactions.

From: https://int.optionsxpress.com/educat...tem=options3_4

You should also note that different brokerage firms have differing policies regarding the automatic exercise of options In-the-Money at expiration. Contact your brokerage to know how your brokerage handles expiration and margin requirements if you do not have adequate cash in your account to perform the exercise.

There is also a good example of why it's usually just better to sell the options, rather than exercise available here: What Are In The Money Options ( ITM Options )? by OptionTradingpedia.com

I would like to keep to own some AAPL shares, maybe 30.

If you would like to keep them, how long would you like to own them?
And how long have you owned the options?

-------------------------------------------------

Let's just take a current example, assuming you made this decision right now (which you obv don't have to do). And we only need to really evaluate one of the options to make my point:

AAPL Options | Apple Inc. Stock - Yahoo! Finance
AAPL closed at 398.62. The 370 Jan Call closed at 45.06, and the 380 Jan call at 38.90

Based on current market price, if you exercised the 370 call and immediatly sold you would buy at 370, sell at 398.62 and keep the 28.62 difference per share. You would pay a commission on exercise, and another on the market sale. (This would result in a loss on your position of $438)

If you sold the option at the current market price, you would get 45.06 per share. Pay one commission. (This would result in a gain of $1,206) Tax implication: You'd only be taxed on the $1,206 gain as short term cap gains.

By selling the option, you would make $1,644 more than exercise/sell, and pay less commissions to do it.

You could then use those profits towards a purchase of 30 shares of AAPL, hold them for more than a year and qualify for the LTCG 15% max tax rate.

----------------------------

I'm pretty much of the opinion that whenever you're ready to close out the options, that you should just sell the options and buy 30 shares of AAPL.

[Nika]

Wow, JPG thank you for such detailed answers and for you time. It is helpful when I'm just beginning and don't fully understand everything yet.

Tax implication: You'd only be taxed on the $1,206 gain as short term cap gains.

I did not know about short term capital gains! I thought it would be taxed at "ordinary income" rate. At what rate are short term capital gains taxed?

If you would like to keep them, how long would you like to own them?

30 shares? Long term. Possibly years.

My account is with ING, and it does have a margin, never used it though. Not sure if ING allows margin to be used for this purpose. I'll investigate. Again, I could scrape up 37,000 to put there for a few months.

My original post was written when AAPL was at 424. Obviously, the situation is very different now.

Our plan at the time when we bought the options(370 end of August and 380 on Oct. 4) was to exercise one of them at the end of Jan and to sell the other before mid December.

I wanted to sell the 380 one to make some profit and mitigate the risk from holding the 370 to exercise. I was waiting to sell it at 85% profit (which may have been greedy, but I came up with this figure because 370 has reached that price at some point, 380 haven't yet. But I did not want to sell 370 one)

They both expire 3rd week of January, which is around the time apple quarterly figures should come out (they don't announce when precisely).

The options were bought with new iPhone and Christmas season in mind ( think they would do quite well during the holidays, as many people want iPhones and iPads for Christmas). They should sell the boatload. My husband was very accurate in predicting their figures so far (he reads a lot about apple and really understands the company) however, even though he predicted very well as to how apple would do, he did not predict accurately market reaction to those numbers, which often turns out to be quite illogical.

The problem is that the option won't be worth much if we wait until late January to sell it, so if I hold it that long, I might have to exercise. So hence the risk and a tough choice: miss the ride from christmas shopping quarter or be forced to exercise.

So, to restate, my problem with the idea of selling both options is that the option's value decreases when it gets closer to its expiration, so we could not wait as long as we could if we are prepared to exercise (only one of them, we will definitely cell the second).

I'm probably not very coherent here, but since you are so bright you'll probably understand what I mean.

[jpg7n16]

I did not know about short term capital gains! I thought it would be taxed at "ordinary income" rate. At what rate are short term capital gains taxed?

Well short term cap gains are pretty much taxed at the same rate as ordinary income. If you think of STCG as ordinary income, you'll be pretty much spot on for most purposes. They are technically in their own category. I only mention it more to make a distinction for long term capital gains if you hold the 30 shares over 1 year.

It can get kinda complicated, and you don't need to know all the ins and outs to be a successful investor. Just know that there is a benefit to holding an investment longer than 1 year. For options, that clock starts when you purchase the contract.

TurboTax® - Capital Gains and Losses

Since just selling the option in the market would be STCG, and exercising and immediately selling the shares would also be STCG, there is no difference tax-wise between the two options.

The only tax difference would be on the gain in the 30 shares you keep.

If that isn't complicated enough, this may be -- on those 30 shares, you need to compare the excess time premium on the entire option to the tax benefit on the unrealized gain of the position you keep.


The question really is, what is the tax benefit on those 30 shares?

If AAPL is trading at $400, pretty much $0. As your basis is $403/share (370 strike + 33 option premium), you pretty much break even. If AAPL is at $500/share, maybe $400 total tax savings. So if selling the option in the market makes more than $400 in excess premiums, selling is the way to go.

Where did that $400 figure come from?

30 shares * $500/share = $15,000 proceeds
30 shares * (370 + 33)/share = 30 * 403 = $12,090 basis
Gain = Proceeds - basis = 15,000 - 12,090 = $2,910 gain
Tax savings from 25-30% down to 15% max rate = 10-15%
Tax savings = 15% * 2,910 = $436.50

The problem is that the option won't be worth much if we wait until late January to sell it, so if I hold it that long, I might have to exercise. So hence the risk and a tough choice: miss the ride from christmas shopping quarter or be forced to exercise.

So, to restate, my problem with the idea of selling both options is that the option's value decreases when it gets closer to its expiration, so we could not wait as long as we could if we are prepared to exercise (only one of them, we will definitely cell the second).

Well since we're teaching options here

There are two components to the value of an option:
1) the inherent value of what the contract allows you to do (intrinsic value)
-The contract allows you to exercise, buy the shares and sell them at the current market price.
2) an additional premium included for the value remaining on that contract (time premium)
-The closer you get to expiration, the lower this time premium will go.

So as you near expiration, the benefit of selling the option versus exercising decreases. As of right now, there is significant value to selling vs exercising. At current prices, this time premium more than offsets the potential tax savings on those 30 shares.

So when you say the options will be 'worthless' and 'forced to exercise' - that's not true. The option will always be worth at least as much as exercising and selling. And you always have the ability to sell the contract. Though if the gain on those 30 shares is large enough, the tax savings on that gain may be enough to offset the time premium close to expiration.

I'm probably not very coherent here, but since you are so bright you'll probably understand what I mean.

Thank you That means a lot to me. Thanks

From what you said, I got that you guys were making a short term play hoping that earnings figures in the 4th quarter will be really good, and hopefully lead to a really good price in early January.

Hopefully those crazies in the market will value the shares as good as their earnings Best of luck with that!


And hopefully this super long post didn't confuse you too much...

[Nika]

JPG, thank you very much for the long post. It did clear up some things and confirmed that I understood other stuff correctly. You've been very helpful!

And I did contact share builder and they confirmed that I do need the money in the account to exercise. I assumed before that I only needed to have enough if I exercised at the time where the profit from immediate sale would not cover it, but I was wrong. Good thing I discovered it now, and it was because you brought up that point.

One more small question -- is there usually a difference in these "cash on hand" requirements if you are exercising early or exercising automatically on the expiration date? Are these treated differently?

[jpg7n16]

One more small question -- is there usually a difference in these "cash on hand" requirements if you are exercising early or exercising automatically on the expiration date? Are these treated differently?

Nope. If you're responsible to deliver cash to purchase upon exercise, that won't change whether you elected to exercise, or if it happened automatically.

Either way, you'd still be responsible for making sure there was enough available to fund the purchase.

[Nika]

Moment of truth is nearing

I think we have to decide by tomorrow!

We have 1 option left - $370 call. We sold $380 call when we got nervous for only $300 profit

So now our choices are either sell the option at $2,145 profit now or exercise and hold the stock until after Apple announces quarterly earnings on the 24 January 5pm.

Are you the betting type? What would you do?

[Slug]

I would sell the option. If you want to bet, use the gains to buy another 1.

[KTP]

I must assume your option is not a Jan call since they expire on the 20th and you mention waiting until the 25th. A feb $370 Apple call is worth $5655, and you paid $3300 (nice job!)

Here is what I would do:

Sell the Apple call today and book a profit of $2300 or so.

Set aside $600 to pay tax and use the remaining $1700 to buy 4 actual shares of Apple.

Do this several times on the dips and pops, and eventually you will have a signifcant amount of actual apple stock at no net cost.

[Slug]

I saw this article today and thought of you.

Apple Beats Or Misses? I Don't Care - Seeking Alpha

[Nika]

KTP, the option has a Jan call and it expires before the announcement. I just checked and the current price is $5,895

The only way for us to bet on the announcement is to exercise the option and keep the stock until after the announcement, than sell it. (which could go either way when it comes to the stock price. people may have such unreasonable expectations that even enormous profits won't satisfy them. Or, apple could make unprecendented amount of money this quarter. I think they did really well. On the other hand, Apple knows how much they make simply because they sell everything that they make. So since they know their capacity to manufacture, they know how much they sold.)

A third option may be to exercize and sell 35 stocks before the announcement, and 35 after. (we wanted to keep 30) Though this way I will need to pay the fee for selling stock twice.

Slug, I don't yet understand everything in the article.