Put and qualified covered call option on same equity results in straddle treatment.

• Author: Kautter, David J.

In Rev. Rul. 2002-66, the Service held that if a grantor of a qualified covered call option (QC) holds a put option on the same underlying equity, the purchased put will cause the stock and the QC to be part of a larger straddle and ineligible for the Sec. 1092(c)(4) exception to straddle treatment for QCs. To be a QC, a covered call option cannot be a part of a larger straddle; see Sec. 1092(c)(4)(A)(ii).

The ruling outlined three fact patterns, in which the IRS assumed that (1) an inverse relationship exists between the value of the underlying equity and that of each option position; (2) because of the inverse relationships, each option position substantially diminishes the risk of holding the equity; (3) the acquisition of the put option substantially diminishes the risk of loss for the combined position, consisting of the equity and the QC on that equity; and (4) the call option is a QC under Sec. 1092(c)(4)(B).

Fact Patterns

In the first scenario, a company purchases 100 shares of a corporation's stock for $100 per share, writes a 12-month call option on 100 shares with a $110 strike price, and purchases a 12-month put option on 100 shares with a $100 strike price. The Service determined that all of the positions are part of a larger straddle. As a result, the covered call option would not qualify as a QC, so the straddle rules apply.

In the second scenario, a company purchases 100 shares of a corporation's stock on Sept. 3, 2002, for $102 per share. On Sept. 6, 2002, when the stock's fair market value (FMV) is $100, the company writes a 12-month call option for 100 shares with a $110 strike price, and purchases a 12-month put option on 100 shares with a $100 strike price. The Service determined that all of the positions are part of a larger straddle, beginning on Sept. 6, 2002. Thus, the covered call option would not qualify as a QC and the straddle rules would apply beginning on that date.

In the third scenario, a company purchases 100 shares of a corporation's stock on Oct. 1, 2002, for $102 per share. On Oct. 3, 2002, when the stock's FMV is $100, it writes a 12-month call option on the 100 shares with a $110 strike price. On Dec. 2, 2002, when the stock's FMV is still $100, the company purchases a 12-month put option on 100 shares with a $100 strike price. The IRS held that before Dec. 2, 2002, the combination of the QC and the underlying shares would not be part of a larger straddle. However, beginning on that date, all of the...