Index options provide a multitude of benefits over corresponding ETF options, including cash settlement and the elimination of exercise and assignment risks. Additionally, index options also provide potentially favorable taxation for investors and advisors using these products for income and portfolio protection.
How are options taxed?
When buying and selling securities regardless of product type, tax rates are determined based on the holding period in addition to a variety of factors. Generally, a product held longer than 365 days is considered a long-term investment and taxed at a favorable rate. On the other hand, positions held less than 365 days are taxed at a less favorable short-term rate. Products that fall under short-term holding periods are taxed as ordinary income, whereas those categorized as long-term holding periods are taxed at a lower fixed rate. For the tax year 2022, the highest tax bracket for short-term capital gains is 37% and the highest bracket for long-term capital gains is 20%.
What advantages do index options provide for taxation?
Options are typically used for income and portfolio protection and not often held for greater than 365 days, therefore are taxed at shorter-term rates. Broad-based index options offer an advantage as they are considered a Section 1256 Contract and subject to a 60/40 rule. This rule states that 60% of gains are taxed as long-term and 40% as short-term regardless of the holding period. Therefore, trading broad-based index options offers a unique tax advantage.
An options investor can gain exposure to the same broad-based index via an ETF option or an index option. Often, an ETF option and Index option offer similar exposure and notional value. However, the index option investor can potentially keep more gains after tax due to a more favorable treatment.
- Investor A invests in a Nasdaq-100 ETF (QQQ) and makes $10,000 in annual profit
- Investor B invests in a Nasdaq-100 Index option (NDX) and makes $10,000 in annual profit
Both investors are married filing jointly under the 32% tax bracket and held the position for less than 365 days.
Both Investor A and Investor B can gain exposure to the same product and subsequently creating identical gains in this example. However, Index Option trader Investor B was able to recognize a 10.58% additional gain after taxes, due to the favorable treatment of broad-based index options.
Mark-to-Market Rules
Lastly, each Section 1256 contract held at the last business day of the tax year is treated as a closing transaction as if it were closed at fair market value. The contracts will be taxed at the favorable 60/40 rate and a new basis will be marked to market regardless of how long the options were held. Additionally, under this rule, wash sales do not apply.
Essentially, index options offer a variety of advantages including favorable taxation and mark-to-market adjustment if held through year end. Do keep in mind tax rules are subject to change and always consult a tax professional regarding your specific portfolio and scenario.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Tony Zhang
Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Chief Strategist for OptionsPlay, Tony currently leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative reimagined solutions to clients and the users they seek to serve. Previously, he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.
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