Options and Taxes

“Death, taxes and childbirth! There is never any convenient time for any of them”

-from “Gone With the Wind” by Margaret Mitchell.

Despite being a very important part of investing, not much has been written about taxation and options. This is probably because not much can be written. The first paper to write about options and taxes was by Myron Scholes in 1975, “Taxes and the Pricing of Options”. His conclusions were:

  • If people have different tax rates then options will be valued differently by different people. So instead of one value, we will have a band of values. Technically this is true for anything that can be traded, and isn’t really helpful unless we know exactly what the tax rates of each investor are.

  • He discusses some trading ideas that don’t apply anymore.

  • He points out that the taxability of dividends reduces the the advantage of selling options.

Then, as far as I can tell, not much was added until 2019. Recently Paul Mason and Steven Utke wrote the paper “Investor Taxes and Option Prices” where they compared the implied volatility of SPY options and SPX options. They controlled for the dividends, expiry dates and American/European exercise features. The only difference they didn’t account for was the different tax treatment of SPY and SPX options. SPX option profits are taxed 60% at the long term capital gains rate and 40% at the higher short term rate.

SPY options have a consistently lower implied volatility. Higher tax rates reduce demand for options

In terms of trading I’m not sure this means much. The differences, while statistically significant, are small. But small differences add up so, if you are selling volatility, the SPX is the way to go.

Euan Sinclair2 Comments