NDX/QQQQ---SPX/SPY---RUT/IWM---Which Options Better???
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Darp and Flsupraguy,
I left out the balance of the article.
60/40 Tax Treatment on Broad Based Options
Options Corner From CBOE, Feb 1 2006
Years ago, professional market makers had several advantages over individual investors. They had state-of-the-art trading software, which was too expensive (sometimes custom written) for individuals. They had access to breaking news and being on the trading floor were able to react to it quickly (speed). Professionalâs margins were risk based and commissions on options and stock were a fraction that charged individual investors.
Change comes quickly. In todayâs world, there are many vendors of wonderful trading software at reasonable prices. Individuals can buy or sell options electronically in nano-seconds. Option commissions for investors and traders are a fraction of what they were, and some strategies at some brokerage firms have risk-based margins.
Professional market makers received one other benefit - 60% of their trading profits were taxed at the long-term capital gains level while the other 40% was taxed at the short-term capital gains level. This is also known as a â1256â, named after the IRS Code section 1256 covering this area.
Are there any listed options where investors receive the benefits of this preferential tax treatment? Thatâs what this article is all about. Broad-Based, Cash Settled Index Options are entitled to 60/40 tax treatment for individual investors and professional traders. They are known as 1256 contracts.
Be careful. Diamonds, SPIDERS and QQQQs are broad based, covering the 30 stocks in the Dow Jones Industrial Average, 500 stocks in the S&P 500 and 100 stocks in the NASDAQ-100. But there is a catch: These are not cash-settled indexes, they are ETFâs, which settle into shares.
Should tax-treatment change the instrument you wish to trade? No, but in some cases maybe it should. Letâs look at an example.
An investor buys 200 QQQQ options, options 1/40th the size of the NASDAQ-100. There is very good liquidity in the QQQQ options ordinarily, easy to enter an order and get filled. Is there a broad based index option that could be used instead to obtain the 60/40 tax treatment? Actually there are 2 broad based index choices, the MNX (1/10th size of the NASDAQ-100) or NDX (full size NASDAQ-100 contract). Rather than trade 200 QQQQ options, you could trade 50 MNX contracts or 5 NDX option contracts. Both of these are â1256 contractsâ, entitling the investor to 60/40 tax treatment. And commissions on 5 or 50 contracts should be less than commissions on 200 contracts. Buying 200 QQQQ contracts at $1.00 is the same dollar risk as 5 contracts of the $40 NDX.
There are a few major differences you must be aware of between broad based indexes and ETFâs.
1. Broad based indexes do not turn into shares of the underlying as an ETF would, they turn into cash.
2. Positions held at the close of trading on December 31st by individuals are taxed âmark-to-marketâ, that is the position is treated for tax purposes as if it were closed out. On January 1st there is a new tax basis for the position.
kny 3
I left out the balance of the article.
60/40 Tax Treatment on Broad Based Options
Options Corner From CBOE, Feb 1 2006
Years ago, professional market makers had several advantages over individual investors. They had state-of-the-art trading software, which was too expensive (sometimes custom written) for individuals. They had access to breaking news and being on the trading floor were able to react to it quickly (speed). Professionalâs margins were risk based and commissions on options and stock were a fraction that charged individual investors.
Change comes quickly. In todayâs world, there are many vendors of wonderful trading software at reasonable prices. Individuals can buy or sell options electronically in nano-seconds. Option commissions for investors and traders are a fraction of what they were, and some strategies at some brokerage firms have risk-based margins.
Professional market makers received one other benefit - 60% of their trading profits were taxed at the long-term capital gains level while the other 40% was taxed at the short-term capital gains level. This is also known as a â1256â, named after the IRS Code section 1256 covering this area.
Are there any listed options where investors receive the benefits of this preferential tax treatment? Thatâs what this article is all about. Broad-Based, Cash Settled Index Options are entitled to 60/40 tax treatment for individual investors and professional traders. They are known as 1256 contracts.
Be careful. Diamonds, SPIDERS and QQQQs are broad based, covering the 30 stocks in the Dow Jones Industrial Average, 500 stocks in the S&P 500 and 100 stocks in the NASDAQ-100. But there is a catch: These are not cash-settled indexes, they are ETFâs, which settle into shares.
Should tax-treatment change the instrument you wish to trade? No, but in some cases maybe it should. Letâs look at an example.
An investor buys 200 QQQQ options, options 1/40th the size of the NASDAQ-100. There is very good liquidity in the QQQQ options ordinarily, easy to enter an order and get filled. Is there a broad based index option that could be used instead to obtain the 60/40 tax treatment? Actually there are 2 broad based index choices, the MNX (1/10th size of the NASDAQ-100) or NDX (full size NASDAQ-100 contract). Rather than trade 200 QQQQ options, you could trade 50 MNX contracts or 5 NDX option contracts. Both of these are â1256 contractsâ, entitling the investor to 60/40 tax treatment. And commissions on 5 or 50 contracts should be less than commissions on 200 contracts. Buying 200 QQQQ contracts at $1.00 is the same dollar risk as 5 contracts of the $40 NDX.
There are a few major differences you must be aware of between broad based indexes and ETFâs.
1. Broad based indexes do not turn into shares of the underlying as an ETF would, they turn into cash.
2. Positions held at the close of trading on December 31st by individuals are taxed âmark-to-marketâ, that is the position is treated for tax purposes as if it were closed out. On January 1st there is a new tax basis for the position.
kny 3
Kny,
I did not see your initial post(page 2). So on 1256 is it as simple as Futures are cash settled and ETFs are not?
I guess can just check the specs of various vehicles, but if there is a general rule on Amer ETFs, Futures, and European stock options, and futures options most interested in it.
If European stock options are cash settled, then that gives motive to trade them tax wise.
TIA
I did not see your initial post(page 2). So on 1256 is it as simple as Futures are cash settled and ETFs are not?
I guess can just check the specs of various vehicles, but if there is a general rule on Amer ETFs, Futures, and European stock options, and futures options most interested in it.
If European stock options are cash settled, then that gives motive to trade them tax wise.
TIA
Hi Darp.
Broad Based
Cash Settled
Index
An ETF might be broad based, but it's not a cash settled index (e.g. IWM vs. RUT). Ignore whether it is European or American style, or AM or PM settlement. SPX is European and AM, OEX is American and PM. Both get 1256.
If you are in doubt, go to the web-site of the exchange (s) that trade whatever it is. They have a fact sheet somewhere that describes the product.
kny 3
Broad Based
Cash Settled
Index
An ETF might be broad based, but it's not a cash settled index (e.g. IWM vs. RUT). Ignore whether it is European or American style, or AM or PM settlement. SPX is European and AM, OEX is American and PM. Both get 1256.
If you are in doubt, go to the web-site of the exchange (s) that trade whatever it is. They have a fact sheet somewhere that describes the product.
kny 3
Found this below. I think both Cash and Futures settled would be 1256 tax wise?
He did not deal with stock settled for some reason.
Are there any cash settled stock futures not indexes that get 1256 treatment? Am guessing not.
What are Options?
From Adam Milton,
Your Guide to Day Trading.
FREE Newsletter. Sign Up Now!
Description of Options Markets and Contracts
Option markets are similar to futures markets, in that they give the holder the right to buy or sell the underlying commodity for a specific price on (European options) or before (US options) a specific date in the future (known as the expiration or exercise date), but options have some significant difference from futures, and are traded quite differently.
Right or Obligation
The main difference is that options contracts only give the right to buy or sell the underlying commodity, whereas futures contract have the obligation to buy or sell the underlying commodity. The buyer of the options contract can choose whether or not to exercise their right, and if they do, the seller of a matching options contract will be obligated to complete the transaction. The seller to complete the transaction is chosen by the options clearing system, which is the Options Clearing Corporation in the US, and Clearstream Banking (a division of the DTB exchange) in Europe.
Options Markets
Options markets include European style options like the following :
ODAX - Cash settled options based upon the DAX stock index of the DTB (Deutsche Boerse) in Europe
OSMI - Cash settled options based upon the SMI stock index of the SWX (Swiss Exchange) in Europe
ESX - Cash settled options based upon the FTSE100 stock index of Euronext (LIFFE) in Europe
and US style options like the following :
EUR - Futures settled options based upon the EUR futures of Globex (Chicago Mercantile Exchange) in the US
OYM - Cash settled options based upon the YM Dow Jones stock index of ECBOT (Chicago Board of Trade) in the US
OZG - Futures settled options based upon the ZG Gold 100 Troy Ounce futures of ECBOT (Chicago Board of Trade) in the US
Options Contracts
Options markets trade options contracts, which specify the underlying security, the expiration date, and the strike (or exercise) price. Day traders can trade options contracts to make a profit on the difference between the buying price and the selling price (when the options are sold before expiration), or to make a profit from the underlying security when they are exercised.
As with futures contracts, options contracts are traded by day traders and longer term traders, and also by non traders with an interest in the underlying commodity. When traded for the underlying commodity, options contracts work the same way as futures contracts, but only give the right to buy or sell the underlying commodity rather than the obligation.
Futures or Cash Settlement
Both European and US style options are settled in either cash or a futures contract in the underlying security when they are exercised. In the money (in profit), cash settled options, are valued using the trading price of the underlying security at expiration, and the profit is realized into the trader's account. In the money, futures settled options, are converted into the appropriate futures contract, which the trader can then buy or sell to realize the profit.
US traders should note that the SEC (the US securities and exchange commission) has placed restrictions on cash settled options, so not all options markets are available to US traders.
He did not deal with stock settled for some reason.
Are there any cash settled stock futures not indexes that get 1256 treatment? Am guessing not.
What are Options?
From Adam Milton,
Your Guide to Day Trading.
FREE Newsletter. Sign Up Now!
Description of Options Markets and Contracts
Option markets are similar to futures markets, in that they give the holder the right to buy or sell the underlying commodity for a specific price on (European options) or before (US options) a specific date in the future (known as the expiration or exercise date), but options have some significant difference from futures, and are traded quite differently.
Right or Obligation
The main difference is that options contracts only give the right to buy or sell the underlying commodity, whereas futures contract have the obligation to buy or sell the underlying commodity. The buyer of the options contract can choose whether or not to exercise their right, and if they do, the seller of a matching options contract will be obligated to complete the transaction. The seller to complete the transaction is chosen by the options clearing system, which is the Options Clearing Corporation in the US, and Clearstream Banking (a division of the DTB exchange) in Europe.
Options Markets
Options markets include European style options like the following :
ODAX - Cash settled options based upon the DAX stock index of the DTB (Deutsche Boerse) in Europe
OSMI - Cash settled options based upon the SMI stock index of the SWX (Swiss Exchange) in Europe
ESX - Cash settled options based upon the FTSE100 stock index of Euronext (LIFFE) in Europe
and US style options like the following :
EUR - Futures settled options based upon the EUR futures of Globex (Chicago Mercantile Exchange) in the US
OYM - Cash settled options based upon the YM Dow Jones stock index of ECBOT (Chicago Board of Trade) in the US
OZG - Futures settled options based upon the ZG Gold 100 Troy Ounce futures of ECBOT (Chicago Board of Trade) in the US
Options Contracts
Options markets trade options contracts, which specify the underlying security, the expiration date, and the strike (or exercise) price. Day traders can trade options contracts to make a profit on the difference between the buying price and the selling price (when the options are sold before expiration), or to make a profit from the underlying security when they are exercised.
As with futures contracts, options contracts are traded by day traders and longer term traders, and also by non traders with an interest in the underlying commodity. When traded for the underlying commodity, options contracts work the same way as futures contracts, but only give the right to buy or sell the underlying commodity rather than the obligation.
Futures or Cash Settlement
Both European and US style options are settled in either cash or a futures contract in the underlying security when they are exercised. In the money (in profit), cash settled options, are valued using the trading price of the underlying security at expiration, and the profit is realized into the trader's account. In the money, futures settled options, are converted into the appropriate futures contract, which the trader can then buy or sell to realize the profit.
US traders should note that the SEC (the US securities and exchange commission) has placed restrictions on cash settled options, so not all options markets are available to US traders.
this was in 2005 and maybe he is wrong, but FYI
Traders Accounting provides tax consulting, entity formation, tax preparation and 401(k) services that help you efficiently establish and maintain your trading business. They teach you the IRS rules that allow you, as a trader, to deduct the widest range of business expenses and fringe benefits available to business owners. The goal is to help you lower your taxes, save you time, and maximize the benefits of your trading business. Visit their web site at: www.tradersaccounting.com
When it comes to tax treatment of the QQQQs, the Internal Revenue Service has yet to offer a lot of As, as in answers. In fact, the IRS has not clearly defined how it prefers to treat a stock index option in general, whether it's the so-called QQQQs, which are based on the NASDAQ, or other broad-based indices such as Standard & Poor's or Dow Jones.
Traders received some direction with the passage of the Commodities Futures Modernization Act of 2000 (CFMA), which expanded the definition of a "broad-based index" (10 or more securities) to include almost all futures and options on stock indices. Based on that, stock index options should be treated as commodities worthy of the Section 1256 tax split, as opposed to narrow-based indices (nine or fewer securities), which are treated as securities and taxed at the ordinary capital gains rate.
But the IRS remains officially mum on that interpretation, leaving options traders and their tax advisors with more QQQQs than answers.
Getting the Most Out of Your Indices
Stock index option traders can receive a significant tax advantage over securities traders under Section 1256. Reporting index capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate
of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
Because of this attractive 60/40 split, most commodities traders forego mark-to-market accounting and its favorable "loss insurance" in order to reap the benefits of the lower capital gains rate.
The major stumbling block to receiving the favored 60/40 tax break comes not from the IRS but from the brokerage firms. That's because your broker reports stock index options as normal option transactions rather than breaking them out. No accountant wants to go through your trades to pull out the QQQQs from your other trading activity.
Because of this, we recommend that all traders open a separate account that only contains their stock index options. It is perfectly acceptable to mix different index trades within this account (Dow Jones, NASDAQ, S&P, etc.) as long as all activity within this account is stock index options. That way, the IRS clearly sees this activity as index options, even though your broker does not break them out that way.
What if you've mixed your QQQQs with your single-stock Microsoft, AOL and Yahoo options? If you try to treat them as 1256, it could flag the IRS. The tax-smart way to handle the situation would be to treat all of the mixed index options as normal stock transactions on Schedule D (or as ordinary capital gains/losses on Form 4797 Part II if you elected mark-to-market accounting) and begin now to segregate your index options next
year.
However you choose to report your stock index options, it is important to be consistent from year to year. Now might be a good time to contact a Traders Accounting tax professional about your specific trading activity in order to minimize your risk in such IRS gray areas.
--------------------------------------------------------------------------------
Jim Forrester, CPA is the Tax Director of Traders Accounting, the nation's leading provider of tax consulting, entity formation, tax preparation and 401(k) services to the trading industry. Traders Accounting teaches traders how to properly set-up their trading business and take advantage of all the money-saving tax strategies available to home-based businesses. Explore the website that Forbes has declared "Best of the Web" for six straight years and find out exactly how to make your trading into a 'business' and receive tax breaks and tax deductions worth up to $25,000 each year. Visit www.tradersaccounting.com for more info.
Traders Accounting provides tax consulting, entity formation, tax preparation and 401(k) services that help you efficiently establish and maintain your trading business. They teach you the IRS rules that allow you, as a trader, to deduct the widest range of business expenses and fringe benefits available to business owners. The goal is to help you lower your taxes, save you time, and maximize the benefits of your trading business. Visit their web site at: www.tradersaccounting.com
When it comes to tax treatment of the QQQQs, the Internal Revenue Service has yet to offer a lot of As, as in answers. In fact, the IRS has not clearly defined how it prefers to treat a stock index option in general, whether it's the so-called QQQQs, which are based on the NASDAQ, or other broad-based indices such as Standard & Poor's or Dow Jones.
Traders received some direction with the passage of the Commodities Futures Modernization Act of 2000 (CFMA), which expanded the definition of a "broad-based index" (10 or more securities) to include almost all futures and options on stock indices. Based on that, stock index options should be treated as commodities worthy of the Section 1256 tax split, as opposed to narrow-based indices (nine or fewer securities), which are treated as securities and taxed at the ordinary capital gains rate.
But the IRS remains officially mum on that interpretation, leaving options traders and their tax advisors with more QQQQs than answers.
Getting the Most Out of Your Indices
Stock index option traders can receive a significant tax advantage over securities traders under Section 1256. Reporting index capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate
of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
Because of this attractive 60/40 split, most commodities traders forego mark-to-market accounting and its favorable "loss insurance" in order to reap the benefits of the lower capital gains rate.
The major stumbling block to receiving the favored 60/40 tax break comes not from the IRS but from the brokerage firms. That's because your broker reports stock index options as normal option transactions rather than breaking them out. No accountant wants to go through your trades to pull out the QQQQs from your other trading activity.
Because of this, we recommend that all traders open a separate account that only contains their stock index options. It is perfectly acceptable to mix different index trades within this account (Dow Jones, NASDAQ, S&P, etc.) as long as all activity within this account is stock index options. That way, the IRS clearly sees this activity as index options, even though your broker does not break them out that way.
What if you've mixed your QQQQs with your single-stock Microsoft, AOL and Yahoo options? If you try to treat them as 1256, it could flag the IRS. The tax-smart way to handle the situation would be to treat all of the mixed index options as normal stock transactions on Schedule D (or as ordinary capital gains/losses on Form 4797 Part II if you elected mark-to-market accounting) and begin now to segregate your index options next
year.
However you choose to report your stock index options, it is important to be consistent from year to year. Now might be a good time to contact a Traders Accounting tax professional about your specific trading activity in order to minimize your risk in such IRS gray areas.
--------------------------------------------------------------------------------
Jim Forrester, CPA is the Tax Director of Traders Accounting, the nation's leading provider of tax consulting, entity formation, tax preparation and 401(k) services to the trading industry. Traders Accounting teaches traders how to properly set-up their trading business and take advantage of all the money-saving tax strategies available to home-based businesses. Explore the website that Forbes has declared "Best of the Web" for six straight years and find out exactly how to make your trading into a 'business' and receive tax breaks and tax deductions worth up to $25,000 each year. Visit www.tradersaccounting.com for more info.
Hi Darp.
At the web site you refer to, they agree with you. I don't know how old that answer is - the first year the Q's traded there was a delay in guidance from Treasury. I have e-mailed that site to ask them if they stand by their claim. I'll report back if they answer. Off to Minnesota to visit the state bird, the mosquito. Back Tuesday.
kny 3 
At the web site you refer to, they agree with you. I don't know how old that answer is - the first year the Q's traded there was a delay in guidance from Treasury. I have e-mailed that site to ask them if they stand by their claim. I'll report back if they answer. Off to Minnesota to visit the state bird, the mosquito. Back Tuesday.
kny 3