QQQ options and 1256

Discussion in 'Options' started by TempusFugit, Jan 8, 2004.

  1. It's pretty obvious - options on ETFs like the Qs are the same as options on any other equity (the ETFs themselves are merely equity securities regardless of what securities they themselves turn around and invest in).

    The Qs are simply equity shares of a fund that in this case attempts to mirror (albeit not exactly) the Nasdaq 100 index - the Qs are not the Nasdaq 100 index itself and hence QQQ options are not options on the index but rather only on that fund's equity shares and therefore not subject to treatment as anything other than equity options.

    On the other hand, NDX and mini-NDX options ARE options on the outright index and are thus subject to special treatment.

    The IRS may not have issed an "official" statement because it seems so obvious to them too.
  2. So too would I think except that all of the 'experts' seem to say that 'further guidance is needed.' I suppose the counter point would be that if one traded only QQQ options (not the underlying) then one is in fact not dealing in the equity but in derivatives of a 'broad-based' index, complying with the spirit if not the letter of 1256.

    BTW, the tax experts here on ET seem to be saying that QQQ options do indeed qualify for 1256.
  3. I understood the Green Company guy was saying they do NOT qualify. What "expert" is saying that QQQ options do qualify for 1256 treatment?

    And even you exclusively traded QQQ options - you still would NOT be trading derivatives on a broad-based (or any other kind of) index, because the QQQ is NOT an index - it is an equity fund that tries to mirror an index. Big difference.

    The reason some "experts" say "further guidance is needed" is because they think anything that's not explicitly commented on by the IRS falls into the "grey area" - no matter how obvious the issue.
  4. Well, my tax guy says "what is not prohibited is allowed."

    To which we would add: "until it isn't"

    Options traders are risk takers by nature so I suspect I will not be the only one trying the "grey area."
  5. i think they are subject 1256.

    "Tax issues were also solved because the CFMA updated the IRS definition of section 1256 non-equity options to include options on broad-based indices. Broad-based indices are indices with 10 or more stocks; narrow-based indices are indices with nine or fewer stocks. According to the CFMA, futures and options on narrow-based indices will be taxed as securities. Futures and options on broad-based indices will be taxed as commodities.

    This is great news for traders, as almost all indices are broad-based and will be taxed at the lower rate. (Research for this article did not uncover any indices that would be considered “narrow based.”)"


  6. Except that the QQQs are NOT an index. They are an EQUITY FUND that "tries" to mirror an index by buying the associated stocks. But they are classified as equities, hence their options are classified as options on equities - NOT options on an index.

    There are real options on the NDX available.

    Since QQQs are indisputably equities (or is someone going to try to claim the QQQs are an index?), the whole issue of how to classify the options on the QQQs is so obvious that I can't believe anyone can possibly think they're anything other than equity options.

    As far as "if it isn't prohibited it's OK" - a competent tax attorney wouldn't use such an assinine generalization in this case. There are a lot of things that aren't expressly prohibited in the tax code but that are clearly not allowed and the IRS doesn't bother to issue "clarifications" of the "prohibition" because it's obvious (e.g., there's no explicit prohibition or guidance letter about not counting your dog as a dependent even though he's just like your child and it lives in your house and you provide it full financial support - not counting your dog as a dependent is an obvious conclusion from the code).

    Per the CFMA, to be treated as 1256 contracts, the options explicitly have to be NON-equity options (i.e., options on something that is NOT an equity). All ETFs (regardless of what the fund's portfolio is based upon) are classified as (and taxed as) equity securities.

    So, unless you can somehow turn that on end and make the case that the classification of the Qs is wrong and they are instead a broad-based index and not an equity (which you can't do), it clearly follows that options on them or any other ETF (which are defined to be equity securities) can only be classified as equity options and therefore not subject to 1256 treatment.

    Quote from Kay Thomas, author of Consider your Options - Capital Gains, Minimal Taxes:

    I seem to be in a minority thinking the answer is clear. I've always said these items can't be section 1256 contracts because they settle in shares of the ETF. An option to buy or sell stock can't be a section 1256 contract, and ETF shares are stock, at least by any definition used in the tax law. So I'm really not sure why there is any doubt on the issue.

    If you buy and sell cash-settled options on a broad-based index, you're dealing with section 1256 contracts. The CBOE brochure states that their cash-settled options on the Dow index is a 1256 contract, and I have no quarrel with that. I haven't figured out yet why people think the tax status of options on the ETFs is unclear, apart from the fact the IRS hasn't issued a ruling on this specific product. To the best of my knowledge the IRS has always said an option has to settle in cash to fall within this definition.