In the week of Jan. 11, GameStop stock ("GME" on the NYSE) soared as much as 115.32 percent. Short sellers and options traders were at the core of the scramble and some of them got lucky. Others were left with expired options contracts, which were ultimately worthless.
This is just one example in an ever-growing line of options face-offs. While options traders may not be thinking about taxes for their returns and losses, it's important to understand the tax nuances of an already complicated trading strategy that's grown about 50 percent in the last year.
How an options contract expires worthless
An options contract can come in two key forms — put or call. A put option refers to a contract where the strike price (or target price) is lower than the current market value. Meanwhile, a call option refers to a contract where the strike price is higher than the current market value.
Each contract has a target date and they expire once that date hits. When a put or call expires, contract holders lose the money in certain instances. Specifically, an expired call option doesn't have any value if it trades below the strike price. An expired put option doesn't have any value if it trades above the strike price.
Refer to this IRS publication when your option expires
In IRS Publication 550, there's information about what happens to a call or put contract that expires come tax season.
When puts and calls expire, the holder reports the cost of the contract as a capital loss upon the contract's expiration date.
However, the writer for either type of contract receives a short-term capital gain, so they must report that. It's always a short-term capital gain, even if the contract was held for more than one year.
Capital losses can counteract your capital gains — to a degree
Capital losses aren't fun — until it's time to report your taxes. Capital gains require tax payments (short-term gains tax for securities held for less than a year are taxed at income rates, while long-term gains tax is much lower).
Investors with capital losses can use a certain amount of the losses to offset capital gains. For 2020, capital losses are limited to $3,000 per year for individuals or $1,500 per year for those who are married and filing a separate return.
For big-time investors, this may not make a huge difference. But for average investors (and those who took a hit on their options contract), it's a useful offset.
An expired contract is easier to tax than an exercised contract
After you exercise an options contract, taxation becomes a bit trickier. The process involves calculating how long you held the contract for, what you earned over your cost basis, whether you were a holder or a writer, call and put formulas, and more.
Perhaps that — and the capital loss offset perk — are silver linings for options contracts that expire worthless.