This Tax Season, Know Your Options

Trading in options can be tricky, but the tax consequences of those trades can be even trickier.

Options are contracts that give the holder the right to buy or sell a specified number of shares of the underlying stock at a specified price per share (the strike price) by a specified date (the option expiration or exercise date). Call options grant the holder the right to buy shares; put options guarantee you the right to sell shares.

In short, if you buy a call option you're betting the underlying shares will increase in price by the exercise date. If they do, you exercise your options and buy the shares at the specified (lower) price. If they don't, you let the options expire and all you've lost is the premium, or what you paid for the options contract.

Put options essentially work the same way in reverse: If you buy a put option, you're betting the underlying shares will decrease in value by the exercise date. If they do, you exercise your options and sell the underlying shares at the specified (higher) price. If they don't, you let the options expire and all you've lost is the price of the options contract.

Like the underlying stocks themselves, option pricing depends on a variety of factors. These include supply and demand, the length of the option period (the farther off the expiration date, the less risky the option, so the premium for the options contract will be higher) and the volatility of the underlying stock (the more volatile the stock, the riskier the option contract and the more expensive it will be).

Puts and calls can be used to make bets on stock price movements, or as a way of protecting paper profits. (For more on options strategy, see Cut Your Risk With Call Options or check out TheStreet.com's In the Money Options Coverage.)