Advantages Of Trading Options On Futures

Advantages of trading options on futures

By: Brian Benson, On Course with Options

What is Section 1256?

Advantages of trading options on futures

For traders who are subject to US tax regulations and file Federal tax returns in the United States, there’s a rather useful, but not widely known, portion of the tax code called Section 1256.

Section 1256 provides for a 60/40 split between long-term and short- term capital gains tax treatment.

Tax Advantages of Trading Futures and Options on Futures

This split treatment on capital gains is regardless of the holding period. Moreover, Section 1256 allows for much simplified summary reporting on your return. Also allowed by Section 1256 is the ability to carry back losses to previous years rather than just the ability to carry losses forward as with ordinary capital losses.

Section 1256 Tax Savings for Traders

In general, gains from trading and investing fall into one of two categories – short-term gains and long-term gains.

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Short term gains are taxed as ordinary income at whatever ordinary rate (currently 10 percent to 37 percent) the taxpayer happens to be in. Long-term gains are taxed at anywhere from zero percent to 20 percent depending on which ordinary tax bracket the taxpayer is in.

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It’s generally an advantage to classify gains as long term to get the lower tax rate, but that requires a holding period of more than one year. For active traders our gains more typically fall into the category of short-term gains and are taxed at ordinary income rates.

Certain futures contracts and options on futures are categorized as Section 1256 contracts.

Advantages of trading options on futures

Section 1256 contracts include:

  • S. regulated commodity futures and options on those futures
  • Futures on major indexes and options on those futures
  • other non-equity options

Like most things tax-related, specific IRS rules and guidance can be complicated.

There are several additional asset classes classified as Section 1256 contracts that are beyond the scope of this article.

Official details regarding Section 1256 contracts and 60/40 tax treatment can be found in IRS Publication 550, available here:

Summary Reporting

Trading Section 1256 contracts does significantly simplify compliance and reporting in addition to allowing for tax savings.

Section 1256 contracts are market-to-market, so unrealized gains and losses at year-end are reported along with realized gains and losses on closed trades for the tax year.

For Section 1256 contracts, you receive a relatively simple 1099-B from your broker that reports your aggregate profit and loss on those contracts.

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When you prepare your tax return, you do not have to account for and report Section 1256 gains and losses on individual trades. Instead, your aggregate profit or loss is reported on Form 6781 where the 60/40 split is calculated between long-term and short-term gains. Those gains or losses are then reported on Schedule D where normal capital gains and losses are detailed.

Tax Loss Carryback

Ordinary losses can only be carried forward.

Understanding Futures vs. Options

There’s an additional provision in Section 1256 where losses can be carried back up to three years for years where you have Section 1256 gains.

You can go back up to three years and amend returns for those years where you had Section 1256 gains and possibly get a refund against the capital gains taxes paid in those years.

Commodity Example

Suppose you have an outlook on a commodity like oil you’d like to act on.

You could trade an Exchange Traded Fund (ETF) like USO or XLE, any of the oil majors, exploration and production related companies, or oil services related stocks. Any such trades with a holding period of less than 1 year will be subject to short-term capital gains reporting and taxation.

There is an alternative of trading an asset class falling under Section 1256 that could result in a significant tax savings.

If you trade the WTI oil futures contract, (typically “/cl” or “@cl”, depending on your trading platform) you’ll be able to do summary reporting of those gains or losses as Section 1256 contracts and receive the benefit of the more favorable 60/40 tax treatment.

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Options on such futures contracts are similarly classified under Section 1256 rules.

Stock Index Example

Many traders regularly trade in major index ETFs like SPY, QQQ, IWM, etc. The IRS is not clear on the status of such ETFs relative to Section 1256. Your broker makes a determination subject to IRS review.

Advantages of trading options on futures

As an alternative, all the major indexes can also be traded with futures and options on those futures. While gains with trading ETFs such as SPY, QQQ and IWM will likely be treated as ordinary gains and be taxed at short term capital gains rates (for positions held one year or less), the futures alternatives such as @es, @nq, and @rty are all treated as Section 1256 contracts for tax purposes.

A Word About Leverage

Similarly, the options on these futures are also treated as Section 1256 contracts.

Volatility Example

Volatility products like VIX futures and options on those futures are considered Section 1256 contracts. However, the many ETFs (and options on those products) based on the VIX are a bit of a grey area when it comes to classification as Section 1256 contracts.

As always, it’s a good idea to check with your broker and tax advisor for clarification.

Strategy Summary

Because of the tax benefits of trading Section 1256 contracts, executing those trades in taxable accounts can reduce the overall capital gains taxes owed. For ETFs, stocks and stock options which do not fall under Section 1256, based on tax considerations there can be an advantage to executing those types of trades in tax-deferred (IRA) or tax-free (Roth IRA) accounts.

Futures Options Trading - Pros and Cons

However, trading Section 1256 products in taxable accounts can provide significant tax savings. As always, consult a qualified tax advisor to determine what is applicable to your situation.


Disclaimer:  The author is not a tax or financial advisor and the following should not be taken as financial advice.

This is by no means a complete discussion of the pros and cons of trading and/or investing.

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Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.