Investor Taxes and Option Prices

We examine whether tax-sensitive investors play a significant role in options markets by examining whether option prices reflect investor taxes. Existing empirical option pricing literature ignores taxes. We exploit a unique setting where ``index'' options on the S&P 500 Index (SPX) and nearly identical "non-index'' options on the exchange traded fund (ETF) tracking the S&P 500 Index (SPY) face different tax treatments. We find that higher investor taxes reduce option prices, indicating tax capitalization in options. We find consistent results when analyzing options around the investor tax changes enacted by the American Taxpayer Relief Act (ATRA) of 2012, and for options on stock indices other than the S&P 500 (e.g., Russell 2000). Altogether, our findings provide new evidence of an additional item-investor taxes-influencing option prices, suggesting that tax-sensitive investors play a non-trivial role in options markets and that taxes warrant consideration in broader options research.