5 Tips to Reduce Taxes When Trading Options

Avid options trader? These 5 tax tips could help you avoid getting nickel-and-dimed this tax season.

Justin Nugent

This article was last updated on 01/10/2023.

Options trading can be a great way to make money, but it can also be expensive due to the taxes and fees associated with it. Fortunately, there are several ways to reduce the amount of nickel and diming you may encounter when trading options. Here are a few tips: 

1. Choose the Right Broker

First, this isn’t a tax tip, but make sure to choose a broker that offers low commissions and fees for the style of trading you most frequently perform. For instance, if you’re a swing trader, who mostly makes large orders every month or two, but isn’t a high frequency trader, you may enjoy a commission set-up somewhat like the one offered at Options AI, which offers a flat $5 per-trade fee regardless of trade size. 

However, if you’re a high-frequency trader, scalping many times throughout the day, a commission structure like that may rack up absurd fees that eat into your overall profit. For a high frequency trader who still wants solid order execution, you may opt more for an IBKR or a Thinkorswim, who offer $0.65 per contract, per trade fees.

More importantly for some traders, many brokers also offer tax-advantaged accounts such as IRA or Roth IRA accounts. These accounts allow you to defer taxes on your profits until you withdraw the money — particularly helpful for people who were already interested in learning to trade options on their Roth IRA accounts, or who are planning to hold onto their investments until retirement.

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2. Utilize Tax Loss Harvesting

You have have heard about tax loss harvesting as the ubiquitous reason for why the market is down on any given day near the end of the year — but it’s more than that. Tax loss harvesting isn’t just for hedge funds — it’s a useful tactic to lower your tax bill when trading stocks or options. 

If you have experienced losses from your options trading, you can use tax loss harvesting to offset some of your taxable gains. Tax loss harvesting is a strategy in which you sell a security that has experienced a loss in order to offset any realized gains in other investments. This can help reduce your overall tax liability. 

Imagine this: In 2022, you took profit on an energy position that was up big. And with that comes a big tax liability. However, you also hold a Tesla position, which is looking sad — it’s down significantly. In order to offset those energy gains, you could sell your Tesla position, “realize the loss,” and simultaneously lower your total overall gains for the year. 

If you’re still interested in investing in Tesla, you could look to a similar investment, such as an EV ETF, a high-growth tech ETF, or even the consumer discretionary ETF XLY, of which Tesla is the second largest position. In any case, you would be happy you did it when your tax bill comes in.

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3. Consider Long-Term Gains

If you hold onto your options for longer than one year, they are taxed at long-term capital gains rates, which are always lower than short-term rates. This can help you save money on your taxes. In order to achieve long-term gains, you would have needed to plan it out ahead of time, by purchasing LEAPS.

LEAPS, or long-term equity anticipation securities, are simply option contracts that expire more than a year from the time you purchase them. For instance, at the time of writing (January 10th, 2022), the nearest monthly-expiration LEAPS would be the options expiring January 20th, 2023. If held for more than 365 days, you will be able to keep more of your gains (if you have any) when tax season rolls around.

4. Take Advantage of Write-Offs

If you are an active trader, you may be able to write off certain expenses related to your options trading. This includes costs such as software subscriptions and trading platform fees. Notably, this is only if you can make the case that you are a trader by trade (no pun intended) and that a large enough portion of your income is from trading stocks or options. 

5. Avoid Wash Sales

Before you can avoid wash sales, you have to what a wash sale is. 

What is the Wash Sale Rule?

The Wash Sale Rule is an IRS regulation that prohibits investors from claiming a capital loss on their taxes when they sell a security at a loss, and then purchase the same security within 30 days before or after the sale. This is done to prevent investors from taking advantage of tax losses without actually changing their investment position.

So then, how can we avoid wash sales?

To avoid wash sales, an investor should take steps to ensure that the same security is not bought and sold within a 30-day period. If a wash sale is unavoidable, the investor should include the disallowed loss in the cost basis of the replacement security. 

When selling a security, an investor should also consider the possibility of a wash sale before making any replacement purchases. Additionally, an investor should avoid selling securities at a loss if they plan to repurchase the same security within a 30-day period.

The Bottom Line: Everyone has to pay taxes, but by following these tips, you should be able to reduce the amount of taxes you owe on your options trades. Remember to consult a tax professional if you have any questions or need help with your taxes.

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