Courtesy of Andy Nybo and TABB Forum

A proposal to reform the taxation of financial instruments would dramatically change the tax treatment for options strategies, potentially decimating trading volumes by as much as 40%. And it is not the so-called ‘fat cats’ of Wall Street that will be impacted by the proposal; instead, the biggest impact will be felt by asset managers and Mom and Pop investors.

The US listed options market is under attack. And if Washington politicians have their way, it is destined to become a mere shadow of its current form, with far-reaching implications for the financial industry and end users such as retail and institutional investors.

The danger lies in a proposal put forth by Representative David Camp (R-Mich.), Chairman of the House Ways and Means Committee, that contains a number of provisions intended to reform the taxation of financial instruments. Of particular interest to options market participants are proposals that dramatically change the tax treatment for strategies incorporating the use of options that have been a mainstay of the business since its inception in 1973.

The proposal will potentially decimate trading volumes, with total industry volumes seeing a decline of as much as 40% if the proposal is implemented in its current form. And it is not the so-called “fat cats” of Wall Street that will be impacted by the proposal. It is also not targeted at toxic flow that is perceived as having a discernible edge over other investors.

The Camp proposal impacts both retail and institutional demand for options. The biggest impact will be felt by asset managers and Mom and Pop investors that are increasingly using options to earn premium income and manage price risk in their equity holdings. TABB Group estimates that in 2012 retail investors accounted for 14% of total US options volume, with traditional asset managers and hedge funds accounting for an additional 38% of the total. It is volume from these two segments that will be impacted the most by the new tax scheme and, given their critical role in the options market, any tax law changes impacting demand from these two segments needs to be closely analyzed.

Rep. Camp’s proposal may be well-intended, but it is the unintended consequences that will decimate the options market. Surprisingly, it is not exotic options strategies designed to avoid taxes that are the focal point of the reform. Instead, the proposal targets plain vanilla listed options strategies used by main street investors that have begun to embrace options as a way to earn income or to hedge equity ownership.

Under current law, losses and gains resulting from options trading are treated as either long- or short-term capital gains, depending on the type of option and strategy. However, the Camp proposal treats these same transactions using a drastically different framework and includes a number of provisions that will result in many common options strategies triggering a taxable event on underlying holdings of equities. For example, if an investor holding appreciated stock writes a call, the stock will be treated as sold and tax would be due on the gain. The same situation occurs when the investor buys a put to hedge against a decline in the stock.

The Camp proposal, however, treats losses somewhat differently than gains. If there is a loss in the stock when an option transaction occurs, the loss cannot be realized until the underlying stock is sold. It seems that Washington wants to have its cake and eat it, too.

Clearly, investors will think twice about using options to either earn premium or hedge their risk, something the proposal seems not to take into account. Not only will investors be subject to immediate tax liabilities, they will also need to maintain scrupulous records for year-end tax and accounting purposes. Once the taxable event occurs, the cost basis for the stock needs to be adjusted. Imagine the level of recordkeeping a stock holder using a monthly covered call writing program would need to collect and maintain? The complexity only gets worse. How does an investor allocate shares if he only buys puts or writes a call on a portion of his position?

The recordkeeping nightmare associate with current tax laws will seem like utopia if these new rules were to kick in. The prospect of the new rules alone is enough to create mind-numbing fear for investors and send chills up the spine of accountants who will certainly see added business in the months and years following any potential implementation of such a rule.

Even though the Camp proposal may not dissuade all investors from using these options strategies, it will have a chilling effect on retail and institutional investors. Although the use of puts as a hedging tool accounts for a minor portion of activity for these sectors, the use of covered call strategies accounts for a much greater share of activity. Under the new rules, there will be little benefit in using premium strategies to earn income and even less desire to use puts to hedge a portfolio.

US options markets are deep, liquid and provide a vast array of market participants with a powerful tool they can use to manage exposures. Volume has remained strong throughout the financial crisis, as investors flocked to the market as a way to manage risk and earn income, and as an efficient way to take directional exposure. But US options market’s very existence is being threatened by misguided tax policy contained in Representative Camp’s proposal.

The options industry needs to continue its efforts to educate Washington on the valuable benefits listed options provide to investors. One such effort is being driven by a coalition of exchanges and the OCC, which are actively working to educate politicians and staffers that are drafting the proposed tax legislation. Its comment letter delves in much greater detail into the types of options strategies impacted by the Camp proposal and is a must-read for all options market participants.