rr-02-66.pdf

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Part I

Section 1092.--Straddles

26 CFR 1.1092(c)-1: Qualified covered call options.
(Also ' 263; 1.1092(c)-2; 1.1092(c)-3; 1.1092(c)-4.)

Rev. Rul. 2002-66

ISSUE

If the grantor of a qualified covered call option holds a
put option on the same underlying equity, is the straddle
consisting of the underlying equity and the written call option
part of a larger straddle and therefore not excluded from
straddle treatment by ' 1092(c)(4)(A) of the Internal Revenue
Code?
FACTS
In each of the following situations, assume that:
1) at the time the call option is written and at the time
the put option is acquired, there is an inverse relationship
between the value of the underlying equity and the value of each
option position;

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2) as a result of the magnitude of the inverse
relationships, each option position substantially diminishes the
risk arising from holding the equity;
3) The acquisition of the put option substantially
diminishes the risk of loss with respect to the combined position
consisting of the equity and the qualified covered call option on
that equity; and
4) the call option is a qualified covered call option under
' 1092(c)(4)(B).
Situation 1
. On August 1, 2002, A purchases 100 shares of
Corporation X stock for $100 per share, writes a 12-month call
option on 100 shares of X stock with a strike price of $110, and
purchases a 12-month put option on 100 shares of X stock with a
strike price of $100.
Situation 2. On September 3, 2002, B purchases 100 shares
of Corporation Y
stock for $102 per share. On September 6, 2002,
when the fair market value of Y
stock is $100, B writes a 12-
month call option for 100 shares of
Y stock with a strike price
of $110 and purchases a 12-month put option on 100 shares of
Y

stock with a strike price of $100.
Situation 3. On October 1, 2002, C purchases 100 shares of
Corporation Z
stock for $102 per share. On October 3, 2002, when
the fair market value of
Z
stock is $100, C writes a 12-month
call option on 100 shares of Z stock with a strike price of $110.
On December 2, 2002, when the fair market value of the Z
stock

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remains $100, C
purchases a 12-month put option on 100 shares of
Z stock with a strike price of $100.
LAW AND ANALYSIS
Section 1092(a) limits the recognition of losses on one or
more positions in a straddle to the amount by which the losses
exceed the unrecognized gain in any offsetting positions in that
straddle. Section 1092(c) defines a straddle as offsetting
positions with respect to personal property, and ' 1092(d)(3)
treats stock as personal property if the stock is a position in
the straddle and an option on that stock or on substantially
identical stock or securities is an offsetting position in that
straddle.
Section 1092(c)(4)(A) provides that a straddle will not be
treated as a straddle for purposes of '' 1092 or 263(g) if:
(i) all of the offsetting positions making up any
straddle consist of one or more qualified covered call
options and the stock to be purchased from the taxpayer
under such options, and
(ii) such straddle is not part of a larger straddle.
The two clauses of ' 1092(c)(4)(A) work together to delineate the
scope of the exemption from straddle treatment provided by
' 1092(c)(4). Clause (i) requires that, in order to obtain this
exemption with respect to a given straddle, the straddle must
consist only of one or more qualified covered call options and
the stock to be purchased from the taxpayer under the options.

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Even if this requirement is satisfied, however, clause (ii)
precludes the exemption from applying if the taxpayer holds at
least one other position (i.e., a position other than qualified
covered call options and the stock to be purchased thereunder)
that, when considered together with the stock and qualified
covered call options described in clause (i), creates a larger
straddle.
Neither the statutory language nor the legislative history
of ' 1092(c)(4) defines the term ?part of a larger straddle."
Section 1092(a)(2)(B)(iii) uses the same phrase in the definition
of an identified straddle but does not define the term Alarger
straddle.@ The legislative history to ' 1092(a)(2)(B)(iii) also
does not define the term but does state that A[i]n addition, an
identified straddle cannot constitute part of a larger straddle
(for example, a butterfly).@ S. Rep. No. 144, 97
th
Cong., 1
st

Sess. 148 (1981), 1981-2 C.B. 412, 471. An example of a
Abutterfly@ is a commodity straddle consisting of a 5 unit short
position expiring in May 2002, a 10 unit long position expiring
in June 2002, and a 5 unit short position expiring in July 2002.
The relationship among the three positions in a butterfly is
explained in
Leslie v. Commissioner
, T.C. Memo 1996-86, aff=d,
146 F.3d 643 (9
th
Cir. 1998), cert. denied, 525 U.S. 1071 (1999):

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The center position or body of a butterfly spread is twice
as large as either wing, and the time periods for the
delivery of the commodity from the first wing to the body
and from the body to the second wing are equal.
Essentially, a butterfly spread creates two spreads, one
bullish and one bearish. Thus, a butterfly spread presents
less chance of either an adverse or a favorable spread
movement and is, therefore, less likely to result in a
different loss or gain than an ordinary straddle.
The 1981 legislative history to ' 1092(a)(2)(B)(iii), while not
directly applicable to ' 1092(c)(4), supports the treatment of a
qualified covered call option as being ?part of a larger
straddle" if the taxpayer holds one or more additional positions
that substantially diminish the risk of holding the equity by
itself and the risk of the combination of holding the equity and
writing the qualified covered call option.
The legislative history of the qualified covered call option
exception to ' 1092 straddle treatment does not clarify the
meaning of the phrase ?larger straddle" but does discuss
considerations underlying the decision to create the exemption.
The report of the House Committee on Ways and Means contains this
explanation:
One widely used investment strategy that would be affected
by the extension of the straddle rules to stock options and
stock involves writing call options on stock owned by the
taxpayer. The committee believes that it may be appropriate
to exempt these transactions where they are undertaken

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primarily to enhance the taxpayer=s investment return on the
stock and not to reduce the taxpayer=s risk of loss on the
stock.

H.R. Rep. No. 432, 98
th
Cong., 2d Sess. 1266 (1984).
In the three situations described above, the presence of a
purchased put substantially reduces the taxpayer=s risk of loss
with respect to the stock, and also reduces any potential for
enhancing the taxpayer=s investment return through premium
income. In each of the three situations, the put option protects
against a decrease in the value of the stock below the exercise
price of the put option and also reduces the impact of changes in
the value of the stock through the inverse relationship between
the value of the stock and the value of the put option. Both
factors substantially diminish the risk of loss with respect to
the holding of the stock by itself and the risk of loss with
respect to the combination of the stock and the written qualified
covered call option. In addition, when the owner of the stock
acquires the put, the amount of the premium received from the
call option is offset, in whole or in part, by the amount of the
premium paid for the put option, thus reducing any potential
enhancement of investment return on the stock resulting from the
receipt of the call option premium. In effect, when the writer
of the call option purchases the put, the writer gives up
potential enhancement of return on investment to acquire
additional risk protection.

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Accordingly, in each of the three situations described
above, the presence of the purchased put causes the stock and the
qualified covered call option to constitute part of a larger
straddle within the meaning of ' 1092(c)(4)(A).
HOLDINGS
Situation 1. All of the positions in X stock are treated as
part of a larger straddle. Section 1092(c)(4) does not apply to
any of the positions in
X stock.
Situation 2. All of the positions in Y stock are part of a
larger straddle beginning on September 6, 2002. Section
1092(c)(4) does not apply to any of the positions in Y stock
beginning on that date.
Situation 3. Prior to December 2, 2002, the combination of
the qualified covered call option and the underlying shares are
not treated as a straddle for purposes of '' 1092 and 263(g).
However, beginning on December 2, 2002, all of the positions in
Z
stock are part of a larger straddle, and ' 1092(c)(4), therefore,
does not apply to any of the positions in
Z
stock beginning on
that date.
DRAFTING INFORMATION
The principal author of this revenue ruling is Pamela Lew of
the Office of Associate Chief Counsel (Financial Institutions and
Products). For further information regarding this revenue ruling
contact Pamela Lew at (202) 622-3950 (not a toll-free call).