What is a Straddle?
An options straddle is a neutral strategy in options trading that involves simultaneously buying a put and a call of the same underlying stock, strike price and expiration date.
Tax straddle definition. For tax purposes, a straddle is a pair of transactions created by taking two offsetting positions. One of the two positions holds long risk and the other is short.
A tax straddle is a straddle that has been constructed solely as a tax shelter. A taxpayer constructs a tax straddle to artificially create taxable losses in order to offset pre-existing gains from unrelated transactions. One of the two positions accumulates an unrealized gain and the other an unrealized loss. The position with the loss is closed out prior to the end of the tax year, realizing a loss sufficient to counter the pre-existing taxable gains. When the new tax year opens, a replacement position can be created in order to offset the risk from the retained position.
There are 2 classes of straddles: basic and identified. These two classes differ in terms of how transactions become associated into the straddles. Additionally, groups of transactions can also be delineated as Qualified Covered Calls (QCC). This has the effect of excluding that group of transactions from being considered a straddle. However, the individual elements of the QCC can be included as elements of other straddles.
For an identified straddle, any loss is disallowed if there are offsetting positions still open. The basis of the offsetting positions is adjusted by the amount of the disallowed loss. The loss is then recognized when that position is disposed of.
For a basic straddle, the comparison is made at the end of the year. The amount of the loss is compared to the amount of the unrecognized gain on offsetting positions as of the end of year. The amount of the loss in excess of the unrecognized gain (if any) can be recognized, the loss up to this amount is deferred until the following year. At the end of the following year, the loss is then compared to the unrecognized gain as of the end of that year, following the same rule. Of course, if all of the positions of the straddle are closed out during a year, then there will be no unrecognized gain at the end of the year, and all the loss will be allowed.
As you can see, this area of tax is very complex and most definitely will require using a seasoned tax professional. Let’s look at a few examples to better understand this important tax rule:
Example 1 Basic Straddle:
- 05/05/2018 Buy a call option on XYZ for $100.
- 05/07/2018 Buy put option on XYZ for $200.
- 12/01/2018 Sell a call option for a loss of $11.
- 12/31/2018 The put option is worth $205, for an unrealized gain of $5.
Result: $5.00 of the $11.00 loss is disallowed. The $6.00 loss is allowed for the tax year of 2018, and the $5.00 loss is allowed in a later taxable year.
Example 2 – Identified Straddle
Same as example 1, but the fund ‘identifies’ the two transactions as belonging to a single straddle.
Result: The entire $11.00 is disallowed in the tax year of 2018 and the cost basis of the put option is adjusted upward by $11.00.
Example 3 – Covered Call Activity:
You buy 100 shares of XYZ stock on January 5th, 2018.
On December 30th of 2018, you sell short (‘write’) an out-of-the-money call option with an expiration date of June 30th, 2019.
On December 31st, you sell the XYZ shares for a $10.00 realized loss.
The short call option shows an unrealized gain of $5.00 at close of business, December 31st, 2018.
These transactions meet the requirements of being a qualified covered call.
Result: Although the two transactions would normally be tagged as a basic straddle, since they were exempted by being qualified as a QCC, the $10.00 loss is allowed in the tax year of 2018.
There is much more to discuss on this subject, including cost basis, holding period adjustments and disallowed wash sales losses related to straddles. We strongly encourage you to find a trader tax expert or reach out to one of the OTA tax pros advisors.