- The goal of any call option is to make money when a stock price goes up. Your call option will have a strike price and an expiration date. If you execute (or exercise) the stock option on or before the expiration date, you will pay the strike price on the stock, not what it trades for in the market. In a perfect world, the market price of the stock will exceed your call option strike price prior to the execution date. You can exercise the option, buy the stock and sell it immediately for the higher market price.
- When you execute a call option, you buy stock. At this point, you have only invested money: the premium you pay for the option and the price of the stock purchase itself. The IRS does not require you to pay tax until you actually realize the gain, i.e., sell the stock. In the same manner, you cannot recognize any loss until the stock is sold. To track your gain or loss, add the price of the premium to the price of the shares along with any brokerage and trading fees. This is your tax basis, also referred to as your cost basis or net cost. Note that the trading costs of buying and selling stock options are not included on your 1099-B form at the end of the year. It is up to you to track these costs and add them to your tax basis.
- When you sell a stock, the difference between the sale price and the tax basis is your capital gain, or profit. This is considered taxable income and must be reported to the IRS. Add all investment capital gains together, and report them on Schedule D of your 1040 form. If you take a loss on the stock, you may subtract that amount from your gains -- up to $3,000 -- and lower your overall taxable income. Your net gain is taxable at ordinary income rates if you held the stock for less than one year (short term gain) or at a maximum of 20 percent if you held the stock for more than one year (long term gain).
- It is important to consider the tax rules for capital gain as you determine how to execute your call options. If you execute the call option and sell your stock very quickly, you will pay the higher short term capital gains tax. This tax, along with the premium paid for your stock options, will lower your profit potential and may even result in a net loss. It is important to know the "true" price of the stock -- strike price plus premium plus fees and taxes -- as you determine when to sell your stock. Keep in mind that you do not have to execute the call option, you can let it expire if prices do not rise high enough. This limits your loss to the value of the premium and can be written off as a capital loss on your taxes.
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