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From tax-exempt municipal bonds to the groundbreaking tax-advantaged fund structure that helped launch Vanguard’s fortunes, tax benefits have long been a key, if largely unheralded, route to superior investing returns.
Index options’ privileged membership in a special class of tax-advantaged securities known as “1256 contracts” positions them as the latest beneficiaries of that mantle. These tax advantages have the potential to unlock profits for traders taking positions in Nasdaq-100 Index Options (NDX) as AI and the promise of future rate cuts propel tech valuations to unprecedented heights.
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NOTE: This column is written for educational purposes only and does not constitute tax advice. For formal guidance on the tax implications of owning index options, consult a tax professional.
For the sake of simplicity, the examples included do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering any options strategy.
Surging Popularity
For all the exotic strategies contributing to the options-trading boom, one of the most effective also happens to be among the simplest.
The stellar performance of the Nasdaq-100 Index (NDX) has staked owners of Nasdaq-100 Index Options (NDX) to eye-popping returns in recent years. The NDX returned 54% in 2023 to the S&P 500’s 24%. Its 153% gain over the last five years has nearly doubled the S&P 500’s 81% return.
The NDX has even substantially outperformed SPX over much longer time periods. In backtesting of a credit-spread options strategy — index options’ most popular trading strategy — reaching back to 2008, the NDX bested SPX in win rate and nearly doubled its average trade profit.
That impressive track record has seen the popularity of NDX Index Options grow faster than that of rival offerings. While average daily volumes across the index options market as a whole rose 31% in 2023, ADV in NDX Index Options rose at nearly double that clip (59%).
A key reason for the product’s success has been the forward-thinking construction of the index itself. Prominently featuring technology companies while excluding financial firms, the NDX’s makeup arguably better represents U.S. equity performance and the broader 21st-century global economy than those of rival indexes as public companies increasingly tilt toward technology.
The trend figures to continue in 2024 as forecast rate cuts trim capital costs for high-growth tech firms and a cross-sector AI transformation gathers pace. Those dynamics could stake the NDX to further outperformance and deliver added trading-share gains to NDX Index Options this year.
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Special Tax Treatment
But while outperformance is the most visible of NDX Index Options’ advantages, it’s hardly the only one boosting investors’ bottom line.
The cost savings options confer by allowing traders to put up less capital than they would need to take an outright position in a stock or fund are well known. Less heralded, though, are the savings that accrue to traders of profitable index options based on their favorable tax treatment relative to short-term stock, fund, or ETF option holdings.
Derivative contracts including futures, options on futures, and options on broad-based indexes like the NDX are collectively known as “1256 contracts” for the section of the tax code governing their treatment.
Unlike profits on equities, single-stock options, and ETF options, which are taxed at short-term capital gains rates if held for less than a year, profits on 1256 contracts held for less than 12 months are subject to the “60/40 rule.” That means they’re uniquely taxed at a blended rate of 60% long-term capital-gains rates and 40% short-term capital-gains rates.
Since practically all options are held for less than a year, options on futures and broad-based indexes are typically subject to the 60/40 rule.
Hypothetical Example
A hypothetical example helps quantify the tax advantages the 60/40 rule delivers to gains from NDX Index Options versus standard equities, options, or ETF options held for less than a year.
Short- and long-term capital gains tax rates vary according to income level. We’ll assume a short-term capital gains tax rate of 35% and a long-term capital gains tax rate of 15%, which implies an annual income for a single filer of between $243,726 and $518,900 in 2024. (Long- and short-term capital gains tax rates by income bracket for 2023 and 2024 can be found here.)
We can calculate federal tax liability for a $10,000 gain on a stock, option, or ETF option held for less than a year simply enough by multiplying the gain amount ($10,000) by the tax rate (35%) for a federal tax bill of $3,500.
For NDX Index Options, meanwhile, 60% of a $10,000 gain would be taxed at the long-term capital gains tax rate of 15%, for a subtotal of $900. The other 40% of the $10,000 gain would be taxed at the short-term capital gains tax rate of 35%, for a subtotal of $1,400. The total tax liability would be the sum of our two subtotals ($900 and $1,400), or $2,300.
A $10,000 profit in NDX Index Options would thus yield an after-tax gain of $7,700, compared with an after-tax gain of $6,500 for a stock, option, or ETF option held for less than a year — a difference of 18.5%. That additional profit is all the more impactful considering the NDX’s outperformance in recent years.
That said, index options deliver a tax benefit even in a down market. That’s because 1256 contracts are subject to mark-to-market rules that require holders of such securities to report unrealized gains and losses based on the securities’ fair market value at year end.
The mark-to-market rule gives investors the ability to report an unrealized loss at year end to offset other gains, creating an additional tax advantage.
Cost Benefits
Favorable tax treatment is just one of many advantages Nasdaq captured through careful consideration of the best ways to pair the NDX’s exceptional performance profile with the lowest cost structure possible.
Cash settlement of NDX Index Options avoids the risk of forced delivery and the need to have a closing position prior to option expiration, reducing transaction costs.
And because NDX Index Options are “European style,” settling only on their maturity date with no early-exercise provision, they typically carry lower costs than comparable American-style options, for which sellers must price in the added risk of not knowing when a buyer might decide to exercise his or her contract (i.e., “assignment risk”).
NDX index options also boast various and flexible expiration dates to meet investors’ timing needs. While equity and index options both typically expire on the third Friday of the expiration month, NDX has options listed for each day of the week (Monday – Friday) for the first five weeks at all points in time. The activity in shorter-dated index options continue to grow as market participants develop new index-based strategies.
In addition, the NDX Index Options contract offers the largest notional exposure of any U.S.-listed contract at almost $1.7M — nearly four times more than the S&P 500’s corresponding contract and eight times that of the Russell 2000 Index. The NDX Index Options contract’s higher notional value makes it a cheaper tool for hedging stock-market bets than rival index-options contracts.
At the same time, the Nasdaq-100 Micro Index Option (XND), which trades at 1/100th the full value of an NDX Index Option, allows retail investors and asset managers who handle smaller accounts to gain broad-based exposure to the index at lower cost.
For more information on Nasdaq’s suite of index options products, check out the NDX Index Options page.
Those structural advantages build on index options’ reduced idiosyncratic risk relative to single-stock securities, which face pitfalls from events including quarterly earnings announcements, potential takeovers, and even corporate malfeasance that don’t affect broad-based indexes to the same degree.
Taken together, the NDX’s outperformance as well as the tax advantages and cost benefits available to holders of NDX Index Options make the product a compelling choice for investors of all stripes.
If you have questions regarding this essay or wish to connect with a member of the Nasdaq Options Team, please don’t hesitate to reach out to indexoptions@nasdaq.com.
This article was written by Jason Dibble, Co-Founder and Editor in Chief of Curatia, and it first appeared on that platform.
