A call option is a financial contract in which an investor has the option to purchase a certain quantity of a security at a specific price, and within a fixed period of time. However, as the name indicates, the investor is not obligated to make the purchase. Successful stock investing and profitable options trades are wonderful things, however, anytime you receive income from these sources, good old Uncle Sam has his hand ready to take his share of your earnings. Call options are a way for traders to leverage stocks, and they are fairly easy to implement.
When dealing with call options, the price agreed upon is referred to as the strike price, and the predetermined date is known as the expiration date. One call option controls 100 shares of the underlying stock, and the cost to buy a call option is called the "premium".
How It Works
To understand how a call option works, assume you want to place an option on a stock that is trading at $26.50 because you believe the price will go up in the near future Buying 100 shares would cost $2,650, but a call option for the right to buy those 100 shares between now and the date you set only costs 75 cents a share, or $75 for 100 shares. You buy a call option for $75. If the stock doesn't perform as you expect or even drops in price, you only have $75 at risk, rather than $2,650 if you had purchased the stock. If the stock goes up to $30, you can exercise your option and buy the stock. If it goes above $30 a share, you can exercise your option and buy it at the lower price of $30.
Taxes on an Call
When you buy a call option, you do not pay any tax on the premium, you only pay income tax when the shares of stock are sold. In the example from the previous step, if you exercise your option and purchase 100 shares of the stock at $30 per share, you would not pay any tax until you eventually sold those shares. At that time you would add the cost of the call option (the premium), all commission fees, and the $3,000 needed to buy the stock. This would be the total cost for the trade, and would be deducted from the money received for selling the stock, the result of which would be your profit.
Stock and options transactions are reported on Form 1040 Schedule D, "Capital Gains & Losses" of your federal income tax. Column spaces are provided to enter a description of the transaction, the date purchased, the date sold, the cost, the sale price, and the profit or loss. When entering the transaction for the call option, enter the cost to purchase it, but once it is exercised it has a value of zero. The date sold will be the date it was exercised.
When a Call is Not Exercised
When you purchase a call option but then never exercise it, the option expires worthless. Report the expiration date as the date sold on Schedule D and the amount received as zero. This is a loss. While not all options trades are successful, they do reduce the risk of investing in expensive stocks, and although in this case there is a loss of $75, that's a lot better than losing several hundred dollars if the stock price fell several points.
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