I received a number of e-mails from readers regarding My September 16th option column The Bin Laden Hoax. 

One writer asked if the “risk free rate is what one can obtain from parking money in a money market fund or high interest savings account?” The answer to which is yes, although typically, we use the risk free yield on short term government treasury bills as the proxy for the risk free rate. 

Another comment about the Bin Laden hoax, “A quick glance at all this arbitrage and I figure any potential gains would be wiped away by trading costs?” Quite right! A box spread is a strategy that serves market makers and the brokerage community. 

At the retail level, the costs would be prohibitive. Not only from a commission perspective, but from the perspective of the bid / asked spread. The example I cited in the previous column likely involved institutional traders - probably at large US brokerage houses – who essentially crossed the trade. 

In other words, two traders got together and crossed four series of very illiquid options at prices both sides could work with. The trade was probably crossed at cost, which means both sides would simply have to pay exchange fees with zero commission. 

Typically, Market Makers use the box arbitrage to create liquidity without assuming risk. Liquidity is important. Just ask any institutional investor that tried to roll over Bankers Acceptances six weeks ago. In the options business liquidity allows retail investors to buy and sell option positions with relative ease. 

Another question came about how CRA determines tax owed on option premium income. Which is to say; is covered call income treated as a capital gain or as regular income. Another asks; are all covered calls treated as ordinary income, or does it depend on how frequently one uses this strategy?

I am asked this type of question often and have an answer. That said, I am NOT a tax expert, so make of this response what you will. 

If you are a professional trader who makes his / her living trading securities, then premium income and profits will always be treated as income. As well, losses are written off against income. You can request CRA to set you up as a professional trader, but by doing so, you will no longer have the benefit of dealing in capital gains. 

On the other hand, CRA could unilaterally make a determination that you are a professional trader. If CRA were trying to establish that you should be categorized as a professional trader they would look at, among other things, the volume of trading activity and if profits from that activity represented the major source of regular income. 

They would also - probably - be interested in whether you were any good at it. If you were losing more often than winning, they might prefer that you write off losses against capital gains, rather than ordinary income. I would think it unlikely that CRA would encourage bad option traders to change their status. 

Beyond that, assuming you are a regular investor – i.e. not a professional trader whose sole source of income is trading profits – then profits and losses on option trading is treated as a capital gain or loss. 

The premium income received from covered call writing or put writing is treated as income, but which can be applied as income to your capital account (i.e. the income would be treated as a capital gain) or to your income account (i.e. income is treated as ordinary income). It’s you choice. 

There is one caveat to this. Capital gains can only be applied to options where there is physical delivery. Physical delivery simply means that if the option is exercised or assigned, you would physically end up with a long or short position in the underlying security. 

That’s something that does not occur when trading cash settled index options. So, if you are writing on cash settled index options, the premium is treated as ordinary income. 

The bottom line; if you are trading options that have physical delivery, and assuming you are a regular investor (i.e. not a professional trader), you get to treat the income as capital gains or ordinary income. 

Now you might ask why anyone would treat option premium income as anything but capital gains. To which I would respond, ask a Native Canadian. Native Canadians do not pay tax on ordinary income, but are taxed on capital gains.