TAX CONSIDERATIONS, TRANSACTION COSTS AND MARGIN REQUIREMENTS

Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect the profit or loss results of buying and writing options. These are only briefly mentioned in this chapter, but should be understood and taken into account by everyone considering transactions in options.

Notwithstanding the importance of tax considerations, transaction costs and margin requirements, for the sake of simplicity, the examples in this booklet do not take these matters into account. Nevertheless, it should be remembered that their impact may significantly reduce the opportunity for profit and the rate of return obtainable from particular options trading strategies; indeed, their effect may in some instances turn an apparent profit into a loss.

TAX CONSIDERATIONS

The tax consequences of an options transaction depend, in part, on the tax status of the investor and also may differ depending upon the type of underlying interest involved-since the tax rules are not the same for each type of underlying interest-and upon such factors as whether an option is exercised or is the subject of a closing transaction or is allowed to expire or whether an option that is written is covered or uncovered. Some options markets have publications that deal specifically with the tax treatment of various options transactions. These may be obtained from brokerage firms as well as the markets themselves. Readers should also be aware that options transactions effected in foreign markets could subject the parties to tax liability under the laws of the country in which the foreign market is located. Because of the importance of tax considerations to all options transactions, it cannot be emphasized too strongly that the reader considering options should consult with his tax adviser as to how taxes may affect the outcome of contemplated options transactions.

TRANSACTION COSTS

The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions), but may also include margin and interest costs in particular transactions. The impact of transaction costs on profitability is often greater for options transactions than for transactions in the underlying interests because these costs are often greater in relation to options premiums than in relation to the prices of underlying interests. Transaction costs are especially significant in option strategies calling for multiple purchases and sales of options, such as spreads and straddles. Transaction costs may be different for transactions effected in foreign options markets than for transactions effected in U.S. markets. Readers should always discuss transaction costs with their brokerage firms before engaging in options transactions.

MARGIN REQUIREMENTS

Writers of options, other than certain covered call option writers and certain writers of cash secured puts (discussed below), must comply with applicable margin requirements.

In the stock market, margin refers to buying stock or selling stock short on credit. Margin customers are required to keep securities on deposit with their brokerage firms as collateral for their borrowings. But options, unlike stock, cannot be bought on credit under current regulations. In the options market, margin means the cash or securities required to be deposited by an option writer with his brokerage firm as collateral for the writer's obligation to buy or sell the underlying interest, or in the case of cash-settled options to pay the cash settlement amount, if assigned an exercise. Minimum margin requirements are currently imposed by the Board of Governors of the Federal Reserve System, the options markets and other self-regulatory organizations, and higher margin requirements may be imposed either generally or in individual cases by the various brokerage firms.

Uncovered writers may have to meet calls for substantial additional margin in the event of adverse market movements. Even if a writer has enough equity in his account to avoid a margin call, increased margin requirements on his option positions will make that equity unavailable for other purposes.

If a holder of a physical delivery call option exercises and wishes to purchase the underlying interest on credit, the holder may be required to deposit margin with the holder's brokerage firm. Holders of physical delivery options on a foreign currency should be aware that, at the date of this booklet, foreign currency has no value for margin purposes except to the extent that credit has been extended on the same foreign currency.

Margin requirements are complex and are not the same for writers of options on different types of underlying interests. Margin requirements are subject to change, and may vary from brokerage firm to brokerage firm. Consequently, the examples in this booklet do not take margin requirements into account. However, margin requirements can have an important effect on an option writer's risks and opportunities.

Persons considering writing options (whether alone or as part of options combinations, such as spreads or straddles) should determine the applicable margin requirements from their brokerage firms and be sure that they have sufficient liquid assets to meet those requirements in the event of adverse market movements.

[Back to Chapter VIII | Go to Chapter X ]