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Consider a situation where an investor owns a stock for over a year and sells calls against it that expire in about 90 days. You can assume that this is a qualified covered call for tax purposes.

After some time, the calls are deep in the money and the investor is about to get assigned on the calls. If assigned on the calls he will have a 10K long term capital gain. If he buys the calls back he will have a 5K short term loss. If he just sells the stock he will have a 15K long term capital gain. Assuming the investor already has other short term capital gains then from a tax point of view he is better off buying back the calls and selling the stock out right.

Do I have that right? I am also assuming that since he was short the call option for less than a year the loss in the calls would be considered short term. Is that right?

Bob

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    Unless your tax rate is >100%, it is better to make money and pay tax, than lose money and save tax. Jul 18, 2017 at 14:18
  • @D Stanley The calls were sold out of the money so the initial premium was small. Since the stock has moved up, so has the price of the calls. Hence, when if I elect to buy back the calls, it will be at a loss.
    – Bob
    Jul 18, 2017 at 14:37
  • If you just sell the stock, realizing the 15K long term gain, you will then have a naked call position which then subject you to significant upside risk. Jun 9, 2020 at 20:35

4 Answers 4

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Your three options are:

  1. Buy back the calls but keep the stock, taking a net 5K loss (plus a 15K unrealized gain on the stock),
  2. Buy back the calls and sell the stock, for a net 10K gain, or
  3. Let the options settle, netting a 10K gain.

Options 2 and 3 are obviously identical (other than transaction costs), so if you want to keep the stock, go for option 1, otherwise, go for option 3 since you have the same effect as option 2 with no transaction costs. The loss will likely also offset some of the other short term gains you mentioned.

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    @D Stanley. Do you agree that if I buy back the calls, I have a short term capital loss. From a tax point of view, am I not better off with option 2?
    – Bob
    Jul 18, 2017 at 16:26
  • Bob, do you want to hold on to the stock or not? That's your answer. Jul 19, 2017 at 16:59
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    @Bob I seem to remember a tax rule to split an exercised option into short-term/long-term gains/losses for this type of scenario, but I can't seem to find it. If that's not the case then yes I would agree that there could be a difference tax-wise.
    – D Stanley
    Jul 19, 2017 at 17:07
  • @JTP - Apologise to Monica - It's just my opinion but never buy back an ITM covered call for a large loss for the sake of holding onto the stock. The market has a perverse way of making you pay for that. If I'm going to bet on reversal in price, I'd sell the stock and convert the remaining short calls to a bearish call spread or even a backspread. Jun 9, 2020 at 20:42
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Assuming the investor already has other short term capital gains then from a tax point of view he is better off buying back the calls and selling the stock out right.

No, that is not correct. Per IRS Pub 550 circa page 58:

If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss. The gain or loss is long term or short term depending on your holding period of the stock.

If assigned on the position, the call gets folded into the stock transaction and becomes long term.

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if you buy back the now ITM calls, then you will have a short term loss. That pair of transactions is independent, from a tax perspective, of your long position (which was being used as "collateral" in the very case that occurred).

I can see your tax situation and can see the logic of taking a short term loss to balance a short term gain. Referring to D Stanley's answer, #2 and #3 are not the same because you are paying intrinsic value in the options and the skew in #2, whereas #3 has no intrinsic value. Of course, because you can't know the future, the stock price could move higher or lower between #2 and #3.

#1 presumes the stock continues to climb.

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  • Ignoring transaction costs, #2 and #3 are identical as long as doing nothing leads to assignment. If the stock craters then the result is different. Intrinsic value is not an issue here with #2 and #3 because anything paid for the option is received from the stock. Jun 9, 2020 at 20:48
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How about just buy back the call and sell a new one further out of the money at a later date expiration. Your account value should remain the same, with the possibility of further upside and the benefit of a short term capital gains loss.

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  • I do not like the idea of realizing losses by buying back ITM short calls in order to defend/maintain a paper gain in the underlying. The market can have a perverse way of taking your paper gain away. Instead, consider a roll up and out for at worst, a small debit but preferably, a credit. The time to roll a short call up is before the call goes in-the-money in order to avoid buying back a large amount of intrinsic value. The more ITM the short call is, which is the case with the OP's situation, the less attractive the roll becomes. Apr 28, 2021 at 12:08

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