It would be great if you made money on every one of your options trades. The reality is that sometimes an options contract you purchase will expire without ever being “in the money” so you can exercise it and make a profit. If you wrote (sold) the option contract and it is exercised, you may take a loss on the trade. In either case, you can deduct the loss on your tax return.
When you purchase options you are referred to as the options holder. You have the right to buy (call options) or sell (put options) a stock at a guaranteed exercise price. Suppose you purchase a call option with an exercise price of $40 per share. You pay a premium to the option writer. If the stock does not rise above $40 per share before the options expire, you cannot buy the shares from the writer at the exercise price and resell them at a higher market price. Your only sensible choice is to let the options expire unexercised. You will lose the amount of the premium you paid. The IRS considers this a capital loss. If you held the options for more than a year, it is a long-term capital loss. Otherwise it is a short-term capital loss.
A straddle (or offsetting position) occurs when you buy options (usually put options) to protect another investment. For instance, you might purchase put options giving you the right to sell shares of a stock to protect gains on shares you own but aren’t ready to sell. If you haven’t sold the shares by the end of the year, the options expire and you can only claim the amount of the premium in excess of any unrealized gains on the stock. You must wait until the stock is sold to claim the rest of your loss. This is a short-term or long-term depending on how long you held the options.
Losses as Options Writer
When options go unexercised, the options writer keeps the premium as profit. However, if an options holder chooses to exercise the options, the writer may take a loss. In either situation, this is a capital gain or loss. When options are exercised, the writer must purchase the shares at some point. A loss in long-term if the option writer holds the stock for over one year and is short-term if the stock is sold in one year or less. The amount of the loss is the difference between the proceeds of the sale and he cost basis or tax basis. For put options, the premium must be subtracted from the purchase cost of the stock to find the tax basis. For call options, the premium is added to the purchase cost to determine the tax basis.
Like option holders, writers can buy offsetting options to limit losses. For example, if an option writer sells put options with an exercise price of $60 per share, she can buy a put option with the same exercise price. That way, she can sell the shares she must buy if the options she sold are exercised for the $60 per share she must pay, no matter what the market price is. Thus, the two options cancel each other out. The writer collected a premium and also paid a premium. Her loss (or gain) is the difference between the premium paid and the premium received. If the amount paid is greater than the premium received, it is a short-term capital loss. With such a “closing transaction” the stock must be sold almost immediately after purchase, so there are no long-term gains or losses with this type of options trading.