A call option gives the purchaser the right to buy a security at a certain price in the future.
For example, let’s say DrugCo is selling at $100 a share. You pay a premium of $2,000, today, to be allowed to buy 300 shares at $110 a share in thirty days if you choose.
One of three things can happen with your option. One, you could sell it before the thirty days are up. So now someone else would have that option to buy 300 shares at $110 a share after thirty days and you’d be out of the picture.
Two, you could let the thirty days go by and not buy the stock. This normally will happen if the price of the stock after thirty days is less than $110 a share. If the price is still at $100, or at $90 or $108 or $25 or whatever, why would you want to buy it at $110? If you want to buy it at all you’d just buy it in the regular fashion at its current price, not buy it through your option.
Three, after thirty days you could buy 300 shares of DrugCo for $33,000. This normally will happen if the price of the stock after thirty days is more than $110 a share. If the stock is selling for $120 or $140 or what have you, and you have a locked in price of $110 with your option, then it is to your advantage to buy those 300 shares at $110. This is called “exercising the call.”
For tax purposes, you would include the premium you paid with the purchase price. Thus in effect you paid not $33,000, but $35,000 for those 300 shares of stock.
If you then sell those shares later at a profit, anything above $35,000 will be your capital gains. This may come under short term capital gains or long term capital gains, depending on the holding period. The holding period in the case of an exercised call begins the day after you purchased the 300 shares.
Correspondingly, if you sell those shares later at a loss, anything below $35,000 will be your capital loss, again either short term or long term depending on the holding period.
So the key either way is to remember to include the premium you initially paid for the call option in the base price you paid for the stock, in order to determine if you make a profit or suffer a loss for tax purposes.