Laureys v. Comm'r of Internal Revenue

• Decision Date: 25 January 1989
• Docket Number: Tax Ct. Docket No. 23490-85.
• Citation: 92 T.C. 101,92 T.C. No. 8
• Parties: FRANK J. LAUREYS, JR., AND CAROL J. LAUREYS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

92 T.C. 101

92 T.C. No. 8

FRANK J. LAUREYS, JR., AND CAROL J. LAUREYS, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Tax Ct. Docket No. 23490-85.

United States Tax Court

Filed January 25, 1989

P, a member of the CBOE and an appointed market maker in certain CBOE options, engaged in various option spread transactions. HELD, offsetting positions in options do not constitute a ‘similar arrangement‘ under section 465(b)(4), I.R.C., as amended. HELD FURTHER, R's expert report would not be received in evidence; P entered into the transactions for the primary purpose of profit; the transactions were for P's own account and were not dealer activity eligible for ordinary loss treatment. John V. Ryan, III, for the petitioners.

Theodore J. Kletnick and Lawrence Blaskopf, for the respondent.

COHEN, JUDGE:

Respondent determined deficiencies of $310,068 and $171,828 in petitioners' Federal income taxes for 1980 and 1982, respectively, resulting from disallowance of losses claimed by petitioner Frank J. Laureys, Jr. (petitioner), from certain option spread transactions. The questions presented are (1) whether offsetting positions in such option transactions were a ‘similar arrangement‘ protecting petitioner against loss within the meaning of section 465(b)(4); ¹ (2) whether the transactions were not entered into primarily for profit or lacked the substance necessary for recognition for Federal income tax purposes; or (3) whether the losses should be treated as capital, rather than ordinary, losses. A preliminary issue is whether respondent's expert report should be received in evidence.

FINDINGS OF FACT

Many of the facts, including a complete description of the mechanics of option trading, have been stipulated; the stipulated facts are incorporated in our findings by this reference. Petitioners were residents of Woodstock, Illinois, at the time their petition was filed. They filed joint Federal income tax returns for 1980, 1981, and 1982 using the cash receipts and cash disbursements method of accounting.

During the years in issue, petitioner Frank J. Laureys, Jr. (petitioner), was a member of the Chicago Board of Options Exchange (CBOE).

BASIC OPTION TRADING

A stock option is the right to buy or sell a particular stock at a certain price for a limited period of time. The stock in question is called the underlying security. A stock option has two sides, a buyer's side and a seller's side. There are two types of options, call options and put options. An option contemplates future rights and obligations.

In a call option, the seller (or writer) is obliged, if the buyer desires, to sell the underlying stock to the buyer at the buyer's request at any time during the life of the option. The price at which the stock underlying the option will be sold to the buyer of the option is the exercise price, also called the striking price. A CBOE call stock option affords the option buyer this right to buy for only a limited period of time; thus, each option has an expiration date. After this date, the option lapses (that is, expires).

In a put option, the seller (or writer) of the put option is obliged, if the buyer desires, to buy the underlying stock from the put buyer at the buyer's request at any time during the life of the option, at the exercise price. Like call options, CBOE put options have expiration dates.

Four specifications uniquely describe any option contract: (a) the type (put or call); (b) the underlying stock name; (c) the expiration date; and (d) the striking price.

As an example, an option referred to as an ‘XYZ July 50 call‘ is an option to buy (a call) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option expires in July. The price of a listed option is quoted on a per-share basis, regardless of how many shares of stock can be bought with the option. Thus, if the price of the XYZ July 50 call is quoted at $5, buying the option would ordinarily cost $500 ($5 X 100 shares) plus commissions. The seller (or writer) of the call option would receive $500 ($5 X 100 shares) minus commissions.

The price of an option is sometimes called the premium. The price of an option can be viewed as having two elements: the intrinsic value and the time value. Options are temporary assets because they ultimately expire or are exercised. For a call option, the intrinsic value is the positive difference, if any, between the price of the underlying stock and the strike price of the option. For put options, intrinsic value is the difference between the strike price and the stock price, if any. The remaining portion of the option price is called the time value. As an example, XYZ stock is trading at 48 and the XYZ July 45 call option is trading at 4. The premium of the call option is 4. The intrinsic value is 3 (48 - 45) and the time value is 1 (4 - 3). If XYZ is trading at 48 and the XYZ July 50 call is trading at 2, the premium is 2 and the time value is 2. The call price has no intrinsic value because the stock price is below the call's strike price.

Options are often referred to as being ‘at the money,‘ ‘in the money,‘ or ‘out of the money.‘ An option that is ‘at the money‘ has its striking price equal to the market price of the underlying stock. An option is ‘in the money‘ when it is advantageous to the owner of the option (ignoring the price at which he acquired the option) to exercise his right under the option as opposed to acquiring or selling the same number of shares in the stock market. So, disregarding the price (that is, the ‘premium‘) at which the owner of a call option bought the call, it is advantageous for the buyer of the call to exercise when the underlying stock price is higher than the exercise price of the option. For example, a long (bought) call option with a striking price of 100 is ‘in the money‘ when the underlying price of the stock is higher than $100. The buyer (owner) of the call can buy the stock cheaper from the seller of the call than he could buy it in the stock market. A long (bought) put option, on the other hand, is ‘in the money‘ when the underlying stock price is lower than the exercise price of the option. For example, the buyer of the put option with a striking price of 100 is ‘in the money‘ when the stock price is lower than $100. The owner of the option can sell the stock at a higher price to the seller of the put option ($100) than the put buyer can sell it in the stock market (less than $100). An option is ‘out of the money‘ when it would be disadvantageous, ignoring the purchase price the buyer paid for the option, to exercise the option, as opposed to acquiring or selling the same number of shares in the stock market. For the owner of the put, this would be when the striking price of the option is below the market price of the stock. For example, if the put strike price is $100, it would make little sense for the owner of the put to exercise the put at $100 when the put buyer could simply sell the stock in the market for a higher price. Likewise, a call is ‘out of the money‘ when the price of the underlying stock is below the strike price of the option, because it is cheaper to buy the stock in the market than to buy it from the seller of the call at a higher strike price. For example, the call with a $100 exercise price would be out of the money when the stock price is less than $100.

Option positions at the CBOE are closed by offset, by exercise and assignment, or by expiration. Offset means that a party must obtain an equal opposite position. This is accomplished by executing an offsetting (or ‘opposite ‘) trade.

Exercise is the invoking of the right granted under the terms of the option. Assignment is the process of designating an option writer for fulfillment of the terms of a notice of exercise and the subsequent satisfaction of such terms. Expiration occurs in the absence of exercise or assignment prior to the specified date.

For purposes of this case (as set forth in the Joint Glossary filed by the parties), a ‘spread‘ is a position consisting of both long and short options of the same type or of different types in the same class. A type is a put or a call. Butterfly spreads are situations in which a trader holds three positions in the same expiration month in puts or in calls at three different strike prices, the highest and lowest strike positions are one-half the size of the middle position, and the middle position (the body) is long (or short) and the highest and lowest positions (the wings) are short (or long). The highest and lowest positions are equidistant from the middle position. A calendar spread is an option strategy in which the short-term option is sold and longer-term option is bought (or the reverse), in options of the same class and having the same striking price. Either puts or calls may be used in the calendar spread. A variation of the calendar spread is a horizontal time spread in which a short-term option is sold and a longer-term option is bought (or the reverse), of options of the same class but with different striking prices. There are numerous variations of this strategy.

CBOE BACKGROUND

The CBOE is a national securities exchange functioning as a central marketplace, with regulatory and surveillance requirements and the ability to disseminate price, trade, volume and related information. In 1980 through 1983, over 100 classes of options, some with hundreds of series, were traded at the CBOE. A ‘class‘ of options consists of all options on the same underlying security. A ‘series‘ of options consists of all options on the same underlying security at the same striking price and same expiration date and unit of trading.

Prior to establishment of the CBOE in 1973, options were traded over-the-counter with little liquidity. The absence of liquidity in over-the-counter options made closing existing positions by offset difficult. The CBOE for the first time afforded buyers and sellers of options a central...