Did you know that a strategic approach to options trading can not only improve your portfolio but also reduce your tax burden? Tax-loss harvesting is a strategy for options traders in which they can offset capital gains by selling losing positions (capital losses). This common technique can be applied in options trading to maximize profits and minimize tax liability.
Our guide will walk you through how tax-loss harvesting works in options trading, its benefits, and critical considerations on when it’s best to employ this strategy. There are a few drawbacks to tax-loss harvesting that shouldn’t go unnoticed, but we’ll guide you through the entire process of determining which losing positions are best to sell and how to reinvest and allocate those funds in a way that works for you!
What is Tax-Loss Harvesting in Options Trading?
Successful options traders and investors use a strategy called tax-loss harvesting to ensure most of their money stays invested and continues to work for them. In the process, less money goes toward taxes, letting options traders save money in the long run. It can also help traders boost their after-tax returns!
The idea behind tax-loss harvesting is that investors or traders can keep more of their money invested and work for them, and less of it goes to taxes. This strategy uses capital losses from one investment to offset taxes owed on capital gains. Tax-loss harvesting allows traders to sell assets that are down and replace them with reasonably similar investments. You can offset realized investment gains with those losses.
Mechanism
Tax-loss harvesting begins by pinpointing which positions are not meeting expectations or straight up losing you money. You can sell these positions at a loss but use the capital losses to:
- Offset capital gains taxes for that year
- Write off up to $3,000 of capital losses off ordinary income (that is if your losses exceed your gains for the year)
- Defer capital gains tax for the year and use the funds to invest in new positions to drive portfolio growth
Example Scenario
Let’s say you have a call option that has been losing you money, but there’s no way you can return your original investment. It could be due to a bearish market with no interested buyers or to the position becoming illiquid. Whatever the reason, you’re selling the call option because it’s doing you no good for your investment portfolio, and you’d like to reallocate the funds elsewhere where they’d be better used.
Enter the tax-loss harvesting strategy. If you already know about it, you should know that you can take the capital losses on the position you just sold at a loss and use them to offset gains from a put option trade. You’re offsetting the capital gains tax for that option by using the money you made from selling the losing position. Now you’re rid of that position, and your capital gains taxes are taken care of for a position that’s doing well for you.
Why Use Tax-Loss Harvesting in Options Trading?
Tax-loss harvesting is a technique that has helped options traders keep more money for themselves and less money going toward paying taxes for the current taxable year. Who knew that selling securities at a loss could result in some significant tax breaks? The best options traders use tax-loss harvesting to their advantage is to minimize tax liability, offset ordinary income, and defer capital gains tax.
Minimizing Tax Liability
Tax-loss harvesting helps traders lower capital gains, thus reducing their overall tax bills. You sell an investment from your portfolio that’s losing money or underperforming benchmarks. These are called realized losses. You’ll then put that loss to good use by reducing your taxable capital gains for the year. It’s an excellent technique for reducing your tax bill for the current year, thus significantly minimizing your tax liability.
Offsetting Ordinary Income
Realized losses from options can also offset up to $3,000 of ordinary income each year in what is known as a “capital loss deduction.” If a trader or investor has total capital losses exceeding their total capital gains for the tax year, they can write off up to $3,000 from their ordinary income. It’s $1,500 if you’re married or filing separately.
For losses exceeding $3,000, the remaining balance can be carried over to the next year and deducted from tax returns until the entire amount has been used.
Deferring Capital Gains Tax
Traders can defer but not cancel, paying capital gains tax and reinvesting the saved funds. Losses from the sale of one investment can be used to offset gains made from the sale of another investment. This lowers the federal tax owed that year, but the payment will be due the following year. Eventually, you must pay the taxes, but you can keep deferring capital gains tax until your portfolio is profitable enough to pay the taxes and still leave you some capital to keep the growth going.
Key Rules and Considerations for Tax-Loss Harvesting in Options Trading
Before developing an efficient tax-loss harvesting system for your options trading regimen, it’s key to know the basic rules and considerations that go into the process, like the “wash-sale rule,” the tax treatment of options, and long-term vs. short-term gains.
The Wash-Sale Rule
The IRS’ “wash sale” rule prevents traders from claiming a tax loss if they repurchase the same security, a contract or option to buy the security, or a substantially identical position within 30 days before or after the sale. Another thing to consider regarding the wash sale rule is if you get stocks or stock-like bonuses from your employer—check the vesting date of your employee stock purchase plan purchase date to see if it falls within those 30 days.
Consider changing out the stock you’re selling for a mutual fund or an exchange-traded fund targeting the same industry to avoid a wash sale but still invest in an industry you’re interested in. This rule doesn’t apply to cryptos as they’re an unregulated security—you can sell coins with declining value and repurchase them immediately at the same price!
Examples of Wash Sales
Buying back a call option on the same underlying stock too soon may invalidate the tax benefit. The wash-sale period applies to the date of sale plus or minus 30 days. An example of the wash-sale rule would be if you sell a stock on October 4. 30 days before this purchase date was September 4, and 30 days after the date is November 3. To get around the wash-sale rule, you have to have bought the stock before October 4 or after November 3.
A few other wash sale examples include the following:
- Buying a call option
- Selling a stock and then buying it back
- Selling stock in a brokerage account and repurchasing it in your IRA
- Buying a company that merged with the company, you took a capital loss on
- Buying derivatives (warrants, options, etc.)
Long-Term vs. Short-Term Gains
There are two types of gains and losses: short-term capital gains are realized from the sale of investments you have owned for one year or less, while long-term gains are realized after you’ve sold investments you’ve held for over a year.
The other primary difference between these two types of gain/losses is the rate at which they are taxed:
- Short-term gains are taxed as ordinary income at your marginal tax rate. For context, 37% is the top marginal federal tax rate on ordinary income. Rates can be even higher when you factor in state and local taxes, plus the rate could be higher for those subject to net investment income tax (40.8% or higher).
- Long-term gains still fall under the capital gains tax rate, but it’s much lower than that found with short-term gains. The tax rate for long-term capital gains can be around 23.8% when you factor in the 3.8% NIIT (net investment income tax). The rate could be higher if state or local taxes are added to the mix.
Tax Treatment of Options
Different types of options are treated differently for tax purposes. Traders or investors may be subject to capital gains tax or income tax on options, depending on how long they have held them and various other factors. The taxable amount hinges on the type of option a trader is exercising at the time.
- Call Options: Short puts and short calls are always treated as short-term gains or losses, regardless of the holding period. This applies to traders who may have secured short-term capital gains on options held for less than a year.
- Put Options: The elapsed time on a put option runs from when the shares were initially bought to when the put was exercised and the shares were sold. The premiums and conditions on a put are added to the cost basis of the shares if the put is exercised, plus the buy owns underlying securities. You would then take the share’s selling price and subtract this sum.
- Covered Calls: Taxing covered calls depends on how at- or out-of-the-money calls are exercised: the call is unexercised, exercised, or bought back. Traders already long on the underlying security can sell upside calls against that position using a covered call, which can generate income while limiting upside potential.
- Protective Puts: Any gains in selling these stocks would be short-term. The trader can qualify for long-term gains if the stock was held for over a year. In doing so, they could protect that position with a protective put. Traders purchasing a protective put-on share held for less than a year would have their trading period immediately negated.
- Straddles: If the tax losses on straddles significantly offset the gains on the opposite position, traders can claim losses on their tax returns for the current year if they entered a straddle position and disposed of a call.
Steps to Implement Tax-Loss Harvesting in Your Options Trading Strategy
Before you can start integrating tax-loss harvesting in your options trading sessions, you must complete a few steps and become familiar with a few things. We’d encourage you to get as familiar with these strategies and techniques as possible to enjoy more harmonious outcomes as you navigate your portfolio and the challenges of maintaining winning positions in the books.
Identify Losing Positions
How do you analyze your portfolio and determine which options contracts are losing money? There are several metrics that traders can employ to identify the losing positions posted in their portfolios.
- Theta: Use the Theta metric to find out how much an option’s value decreases each day. Theta will show a negative value on long positions, while short positions have positive values.
- Delta: If the underlying asset increases, the delta sign in your portfolio will show if any given position will increase or decrease. Short call positions have negative delta signs, while long positions have positive ones.
- Options Chain: Using the options chain chart, traders and investors can get a general idea of where an option or security might go in the future. Traders can also access real-time information about any security to discover its possible trajectory.
- Open Interest: Generally, higher open interest indicates higher market value and liquidity. Open interest (OI) is the number of outstanding option contracts that are still open.
There are several great reasons why traders would want to rid their portfolios of losing positions, primarily to help preserve their funds and further losses when the markets are bearish:
- Getting rid of losing positions helps traders manage risk. Limited exposure to increasing risks helps them reach their portfolio’s optimum risk profile.
- Dumping losing positions helps traders preserve their capital and protects their initial investments.
- Sell off losing positions that no longer fit your game plan and strategy.
- It’s best to sell losing positions when the underlying fundamentals of your investment get worse, showing that it was a bad purchase from the start.
- Offset gains in other areas of your portfolio and reduce your tax liability by selling off positions that aren’t doing anything for you.
- Sell off losing positions to help improve your blind spots in trading, like the sunk cost fallacy or the endowment effect.
- Take advantage of new opportunities to deliver more profit by releasing lost positions so you can reallocate capital where it matters most.
- Get rid of losing positions early when the liquidity is still there so your capital doesn’t get tied up if conditions worsen and the position becomes illiquid.
- If you’re using technical indicators, it only makes sense to dump losing positions in favor of more profitable opportunities.
- Sell losing positions when the market conditions have changed, and your losing position is unlikely to recover in the new environment.
Determine the Optimal Time to Sell
The best time to sell losing positions is early because there’s still market interest, and not as much liquidity is needed to get rid of these losing positions. When markets are declining or volatile, selling losing positions as early as possible can help traders avoid more significant losses.
Selling losing positions early can also maximize tax benefits while minimizing trading losses. Selling securities at a loss is never ideal, though it’s bound to happen occasionally. You can turn it around in your favor no matter how good you are with trading options. These losses can be used to offset capital gains and other taxable income, which results in traders keeping more of their money for themselves!
Avoid the Wash-Sale Rule
We’ve already discussed the wash-sale rule at length, but what are the best practices you can use to circumvent this obstacle? For your convenience, we’ve outlined the best strategies and techniques for avoiding repurchasing the same option within 30 days to preserve tax benefits.
- Just Wait 30 Days: The simplest way to avoid a wash sale is to wait 30 days after selling the investment. It’s best to record all sales so you can use that information in the future. Remember that this only applies to similar or identical investments in the same industry.
- Diversify Your Portfolio with Multiple Assets: Investing in multiple markets and industries is good. However, you can also have various investments in the same sector where the assets are similar, though not completely identical.
- Keep Records of Sell-Offs: Because the wash sale rules apply to a 61-day window around the sale of an investment or position, it’s best to keep detailed records of your decisions and why each asset within this window isn’t exactly identical.
Reinvest Wisely
Asset allocation is everything in options trading, so reinvesting your money wisely is key to successfully staying on track with your target asset allocation. This means that you are comfortable with the amount of risk you’re taking on each of your investments and that your investments are on pace to deliver the returns needed to fulfill your portfolio’s mission. The main goal for any good options trader is to reinvest in different options or underlying assets to maintain a balanced portfolio while capturing tax benefits.
Keep these fundamental ideas and best practices in mind when you go to rebalance and reinvest:
- Don’t be afraid of uploading successful investments. There’s always the chance they could go lower, so you’re locking in those gains when you sell high. Buying new investment opportunities when they’re low means you’re getting a bargain! This is the essence of good trading and investing!
- Realistically, you’re only rebalancing your portfolio with 5-10% of your assets. It’s not a complete overhaul, so don’t be discouraged or feel overwhelmed.
- Investors with a stock-heavy portfolio don’t really have to rebalance because these positions are dependent on long-term returns.
- Consider how often you’d want to rebalance your portfolio. Many investors do it once a year around tax time. The downside to this approach is that you might be rebalancing when there’s no need.
- Another major consideration when deciding when your portfolio should be rebalanced is whether your target asset allocation has dipped by a certain percentage.
- Some investors can afford to take more risks based on their personal life. Millionaires and billionaires can obviously afford more risk and have higher risk tolerance than the average investor with a modest income. The same can be said for people with no family to support. You might consider reducing risk with your portfolio if you’re disabled or seriously ill or saving for a big-ticket idea like a house or car.
- Consider overall asset allocation. What percentage of your investments are in cash, stocks, or bonds? How is your current allocation compared with the target you have set up?
- Assess your overall risk. You might not take enough risks to grow if you have a large portion of your portfolio in cash. If a good amount of your investments are in bonds, are you taking too much of a risk?
- Make sure your investment fees are as minimal as possible. When buying or selling mutual funds, you must watch out for loads (mutual funds that come with a sales charge or commission. When buying or selling stocks or ETFs, you need to keep an eye out for the commission rates.
- Sell stocks, EFTs, and mutual funds that are high fees, either too risky or not risky enough, haven’t performed to expectation, and have been underperforming compared to their peers.
- They sell bonds when their credit rate has dropped, they are underperforming benchmarks, their returns keep pace with inflation, or the fees are higher than needed.
Risks and Drawbacks of Tax-Loss Harvesting in Options Trading
Though tax-loss harvesting is an acceptable way for traders and investors to use capital losses from one investment to offset taxes owed on capital gains, some risks come with the practice that could make using the strategy more of a hindrance for some traders. We’ve outlined the most significant risks and drawbacks of tax-loss harvesting to give you a clear idea of some of the possible challenges you might come up against when executing this maneuver.
Market Timing Risk
It’s best to buy low and sell high in trading and investing. If you’re focused primarily on selling options early because you want to take advantage of possible tax benefits, you could risk missing out on future gains. It’s almost like throwing the baby out with the bath water. You could substantially improve your portfolio by gaining positions that serve you well, but unloading these prematurely could cause your portfolio to plateau or stagnate.
Plus, the entire idea of unloading losing positions is to use the capital losses from one investment to offset taxes owed on capital gains. You might avoid paying taxes for the year, but another bill will eventually come due, and the hope is that your portfolio’s growth will cover the taxes and still make you a profit. And you cannot accomplish this without having profitable positions driving that growth!
Complexity of Tracking
To properly implement a tax-loss harvesting scheme, traders and investors must keep track of many things simultaneously. First, you must realize when you incur capital losses with any given asset in your portfolio. The next step is to purchase a replacement asset where you can enjoy a capital gain. You’re then using the realized loss with a losing position to offset the capital gain from selling another. Then, you must defer the tax on the capital gain, which lets you keep more of your money in your portfolio, working for you through compounding growth.
As you can see, there’s some true complexity when tracking multiple options trades and their tax implications. We laid out the basic idea of tax-loss harvesting, but you might have to perform these steps for various positions in your portfolio. This is why we’ve brought complex tracking up as a critical challenge in the process of tax-loss harvesting. Sometimes, there’s too much to keep track of!
Potential for Lower Returns
While consistently employing tax-loss harvesting will allow traders and investors to reduce their bill for the current year, pursuing this process results in a lower cost basis for the investment, which could lead to a much more substantial tax bill for future capital gains. Capital gains are the difference between the cost basis (what someone paid for the investment) and the sale price (the profit on the sold investment).
Focusing too much on tax savings could lead to lower overall returns and interfere with your trading strategy, but the rationale behind the strategy is to use these tax payments to fuel extra portfolio growth, which generates enough money to pay off any future tax bills and still make a tidy profit!
Tools and Resources for Tax-Loss Harvesting in Options Trading
Suppose you want to rebalance your portfolio and reduce your capital gains tax. In that case, we’d recommend looking into online tools and resources to help you with your personal tax-loss harvesting strategy. Sometimes, you can use tax software to simplify the tracking process regarding losses and gains in options trading. Still, you can also use automated platforms with helpful tax-loss harvesting features.
Automated Platforms
Several online brokers and other platforms offer traders and investors automatic tax-loss harvesting features and tools. These include the following trading and investment apps:
- Interactive Brokers
- Robinhood
- E*Trade
- Wealthfront
- Betterment
- Acorns
- Charles Schwab
Most financial investing or trading platforms would include tax-loss harvesting as a primary feature, but some platforms drop the ball when including this helpful tool. These are trading apps or websites where tax-loss harvesting is excluded:
- SoFi Automated Investing
- M1 Finance
- Ellevest
- Merrill Guided Investment
Tax Software
While there are plenty of avenues online for traders to use tax software that simplifies the process of tracking losses and gains in options trading, many of these tax-loss harvesting software programs fail to consider the individual tax circumstances that drive most of the true value of harvesting losses.
Using tax software to do all the tax-loss harvesting necessary might work well for:
- An investor who contributes frequently to their portfolio
- An investor who has short-term losses to offset
- An investor who has many individual security holdings
If these factors aren’t present, automated tax-loss harvesting isn’t worth it for many investors because the value lies in capturing losses under the right circumstances. The factors that enhance the value of losses are present. These automated software programs might be great at efficiently pinpointing as many losses as possible. Still, it doesn’t account for whether an investor is the ideal candidate to benefit from a tax-loss harvesting regimen.
Is Tax-Loss Harvesting Right For You?
While tax-loss harvesting might be a solid approach to reducing your capital gains tax while rebalancing your portfolio simultaneously, it might not be the best strategy for every online investor or trader out there. Tax-loss harvesting can help investors minimize tax liability, offset ordinary income, and defer capital gains tax. Still, there are the downsides of the complexity of tracking losses and gains, timing the sell-offs just right so you don’t forego significant profit and the potential for lower returns by accruing a lower cost basis on your investments if your tax bill gets too big.
Take time to evaluate your portfolios and explore how tax-loss harvesting can fit into your trading strategy. Learn more about making the most of your options trading by reading related articles on OptionsTrading.org.
