Tax implications of covered call writing

To assess the tax implications of covered call writing one may choose to first understand what a covered call is and second become familiar with the tax implications associated with the covered call. Since covered call writing can involve both a loss or a gain, the tax implications will naturally vary dependent on the outcome of the covered call. This article will first illustrate the meaning of covered calls and then determine possible tax implications of such a financial transaction.

Defining covered call writing

Covered calls are a stock options trading method involving a combination of a 'long' position combined with a 'call option contract written by the security holder'. In other words the covered call involves two aspects 1) owning the security outright and 2) 'writing' the option to sell the underlying security at a strike price. In this case, the call is covered by the long position held by the security owner which means the call writer has hedged his or her call option with the ownership of the underlying security.

To illustrate further and in more simple terms, investor Y purchases 1000 shares of Greenmail Corporation at a price of $75.00/share, the investor then 'writes' an option to sell Greenmail Corporation at $80.00/share. If the contract costs the buyer $10.00/100 shares the total premium would be $100.00 if a contract for 1000 shares is purchased and the strike price is not exceeded by expiration of the call option. In the scenario the strike price is not met, the seller of the call option will keep the premium plus any difference between the strike price and the purchase price (www.optionseducation.org)

Tax implications

Since the covered call stock option may lead to a loss or gain of money for the seller of the call option, the tax implications can vary. That is to say, if the underlying stock price declines and is sold and the option expires without reaching the strike price, the difference between the profit gained from writing the call option and the loss incurred through sale of stock will determine any loss.

Since the above scenario could qualify as wash sale because of two separate purchases of the same security within a 60 day period where a loss is realized on the underlying stock price, the loss on the sale of underlying stock may not be tax deductible. However, using a cost basis adjustment on the sale and/or purchase of a subsequent option may also minimize the loss from the wash sale. A few potential scenarios and their possible tax implications are listed below however do not replace the advice of a professional tax consultant:

• Underlying stock price decline + sale of call option: Cost adjusted wash sale may lead to tax deductibility on capital loss if an additional purchase of identical or similar stock takes place thereafter.

• Stock price rises + sale of call option: Taxation on capital gain if such gain is not within a tax protected financial instrument such as an individual retirement account.

• Stock price flat (with no sale) + expiration of call option: Taxation of premium will be incurred if the options trading is not within a tax protected investment vehicle.

• Stock price declines with sale + expiration of call option:. In such a case the capital loss may be tax deductible if sold within the same tax year and the retained premium on the call option may be taxed as ordinary income. A cost basis adjustment may not necessarily be applied to the options contract.

Tips for covered call writing and taxation questions

• Awareness: Since the covered call is a combination of two transactions the possibilities of scenarios increases. Being aware of all the possible scenarios and understanding them completely can be helpful in making the most of the covered call strategy

• Research: The covered call is a hedge against a decline in stock price. However, since the stock price could decline dramatically, the benefit of the hedge realized declines with the proportion in the decline of stock price. Such being the case, due diligence into the security, the market and other factors such as technical analysis can also be helpful in minimizing potential loss.

• Tax advice: Contacting and retaining a tax consultant may be advisable in a number of cases especially if one is engaging in a variety of options strategies.

• Tax code and authorities: For additional questions regarding taxation of investment strategies the capital investments division of the government tax authority may also be of assistance.

• Wash sales: Becoming familiar with the tax implications of wash sales when using options is advisable. To gain a more complete understanding of these implications consulting additional resources is advisable.

• Investment strategy: Having a well contemplated and investigated investment strategy may assist in the effective implementation of a covered call and application of corresponding tax scenarios.

• Brokerage services: While the use of a brokerage service may not include tax advice, the brokerage may be of assistance in understanding various uses of options thereby contributing to a better-informed investment strategy.

Summary

Tax implications of covered call writing vary on the outcome of the covered call investment strategy. Since a range of possible scenarios emerge when engaging in such a strategy a thorough knowledge of the tax benefits and hazards can be considered advisable either through independent research or through consultation with a tax professional.

While the information in this article does not replace the advice of a tax accountant or tax authorities it is recommended as a supplementary source of information to an overall covered call options strategy. It may also be helpful to the options investor to consult and cross-reference multiple sources of information to verify and become aware of the complete range of possible investment and tax scenarios.

Sources:

1. http://fairmark.com/forum/read.php?3,28029
2. http://www.investopedia.com/terms/c/coveredcall.asp
3. http://www.optionseducation.org/strategy/covered_call.jsp
4. http://www.irs.gov/pub/irs-pdf/p550.pdf
5. http://www.fairmark.com/capgain/wash/wsoption.htm

What is a Stock Option Straddle?

A stock option straddle is a conservative options strategy that makes use of both upward and downward movements in share prices. This allows the investor or trader to reduce market risk in either direction while still retaining the potential to make money on a movement of company's stock price whether it be upward or downward.(1)

Straddles can be used for long, short and covered positions meaning they can involve the holding of stock in the case of a covered straddle, the simultaneous purchase of call and put options with the same price requirements for long straddles, and the sale of both put and call options in the case of a short straddle.(2)

1. Covered straddle
2. Short straddle
3. Long straddle

Elements in stock options straddles

Depending on which of the above three options strategies is or are implemented the component parts of the stock options straddle can differ. This is because each options straddle makes use of different methods of betting with and against upward and downward price movements. For example, the covered straddle involves selling or 'writing' both call and put options whereas the long straddle involves buying the call and put options. Below are the elements used in stock options straddles.

• The call option

The call option is used in all three stock straddles, however the call option may either be bought, sold and/or covered meaning the underlying stock is also owned outright when covered. The call stock option is a bet that a stock's share price will move upward in price, however selling a call option has the reverse affect.

• Put option:

A put option is essentially the opposite of the call option and is a bet share prices will drop. As with the call option, selling a put stock option is similar to buying a call in the sense it will be a benefit if the opposite price movement occurs.

• Long position

The meaning of 'long' in straddles is different from the meaning of long in regular stock purchases. In long stock option straddles, the long refers to the straddle itself and not the options within the straddle. In other words, normally going long means one is expecting a rise in price, however in a long straddle, the hope is that either the call option or put option will realize their potential be it up or down in price. Thus, the long is the general premise the straddle will be profitable.

• Written stock options

Written options are sold by the options trader and investor instead of purchased, When options are written a premium is paid to the seller, however if share prices move in the unintended price direction, the writer of the option(s) becomes obligated to purchase and sell the underlying stock at the prearranged price.

• Purchased stock options

Purchased stock options can be bought from other options traders. In such case a fee is paid to the writer of both call and put options in the case of a long stock options straddle. In the case of a covered options straddle, the buyer also purchases an equivalent amount of shares as defined by the call option.

Example options straddle

To illustrate the above, the following example explains how a straddle works. Bert first decides what straddle technique he wants to use and chooses a covered stock option straddle. Bert chooses this straddle because he is more convinced stock prices will move up than down, but also wants to hedge or protect against downside risk.

Barney sells both a call and a put option for ABC Corporation to Bert at a price of .10 cents per option share for the put and .12 cents for the call. This strategy more than doubles Bert stock options strategy cost because two options are bought instead of one. The total cost of the option is $220.00 not including the purchase price of the shares should he decide to exercise one or other of the options.

Since this is a covered stock option straddle, Bert also purchased 100 shares of ABC corporation at a price of $20.00 per share, for a total of $20,000.00. Added to the options fee the total becomes $20.230.00 where $20,000.00 is invested capital that Bert owns, $10 is the purchase commission and $220.00 is the stock option fee.

After three weeks, the price of ABC company has moved upward .25 cents to $20.25 and Bert's estimation the price of ABC company would rise has not been realized with one week left to exercise his option. Since Bernie owns 100 shares of ABC, he has made $25.00 in unrealized capital appreciation, not nearly enough to cover the cost of the covered options straddle. Bert lets the covered options straddle expire worthless and retains his 100 shares of ABC for an approximate loss of $205.00. The 100 shares would have to rise $2.05 or 10.12 percent in price for Bert to break even.

Sources:

1. http://bit.ly/bk85yq (Options Industry Council)
2. http://bit.ly/bM95bp (IRS)
3. http://bit.ly/advym2 (Options Trading Tips)
4. http://bit.ly/cHPMaq (Investopedia)

Investing: The Long Put Option

The long put option is the 'option' to buy a leveraged i.e. via collateralized credit, position in a certain number of a businesses shares at a specific price. A fee is charged for the use of an options contract that creates a price spread within which the option user will not yield a profit. Investors use options when they want to increase their potential earnings though purchase and/or sale of stocks. This article will discuss what options and put options are, how they are priced and why investors consider them.

Options explained

Options contracts such as stock options are made with a securities dealer to buy or sell underlying financial products such as commodities, currency, shares, carbon emissions points etc Moreover, as noted above, options investing is a form of leveraged investment in which the investor is able to increase one's investment position for potential greater gain or loss. For example, an investor may purchase 1 option to buy XYZ company before November 30, of a given year. The option itself will be priced by the market and represents a multiple of shares such as 1 option=100 shares.

Options exist in two types calls and puts and can be both bought and sold. Call options have the potential to yield gain if the underlying share price rises whereas put options are the opposite i.e. a drop in underlying share price. The long put option is a type of option where the investor banks on the decline of a price value and retains the 'option' to buy a certain amount of shares at a pre-determined price.

As the name 'option' implies, the option entails the choice to either buy or sell an underlying security and not the requirement. Such being the case, investors may be able to limit potential losses to the premium cost i.e. fee of the option. This is called options "covering" as in covering as short position to protect against a rise in underlying security price.

How options are priced

The cost of options contracts are different from the options price and are three essential variables 1) the fee, 2) the option price and 3) the option loss if any. The fee charged by the securities dealer to facilitate the contract may vary from broker to broker and the option price itself is determined by several variables making it more complicated to determine a fair price.

Option price variables:

The variables that go into the pricing of an option can help an options investor determine if the option is fairly value i.e. not inflated in price and cost. Knowing the fair price of an options contract can assist the investor in minimizing the cost part of the profit venture. Specifically, the variables that go into the cost of an option include the following:

• Underlying securities price
• Market conditions
• Term of the contract
• Exercise/strike price

The above variables determine the risk of the option which in turn translates into price. The higher the risk, the lower the cost tends to be whereas the lower the risk, the higher the price of the option often is. For example, if a strike price i.e. choice to buy or sell, is within 5% of the current underlying security price, the risk of that security not reaching that price is lower than a 10% change, therefore increase the risk cost.

Pricing methods:

There are several ways to price an option in determining whether it is fairly priced or not. Three such methods include 1) mathematical equation 2) investment software and 3) Options guides and 4) investing intuition. Of these methods the last, investment intuition is the most speculative and holds the greatest risk of inaccurate pricing assessment. The first method, i.e. mathematical equation involves entering various variables into a theoretical pricing model to come with a fair price calculation. Investment software and guides may also have build in models or pre-calculated data to assist the investor in this task.

Why use a long put option?

A long put option may be a way to make larger profits in a shorter period of time without risking more than the options premium i.e. the fee for the option contract. Simply put, it can help one make more money faster. However, this is not done without risk and involves making an investment decision based on a number of market and business variables including the unknown future.

Long put option

Source: 'Gxti'; CC By-S.A. 3.0

At best, investors make a strongly calculated and intuitive decision that lowers the probability of failure i.e. loss thereby increasing the probability of maximizing profit. At worst, a poor option decision can lead to a higher probability of failure and a multiplied loss of money since options contracts are leveraged investments. For the latter of the above two reasons, options trading should be considered carefully in terms of available investment funds, loss provisions, investment accuracy, and investment know how.

The long put option is used when an investor, broker or speculator thinks the price of an underlying security will fall. By locking into pre-determined option price, the investor can then buy the put option if the price falls and thereafter sell a greater amount of shares than actually purchased at a higher price than the fallen security value. The difference between the strike price and the actual price of the underlying commodity minus the cost of the contract will then determine any profit.

Sources:

1. http://www.investopedia.com/terms/p/putoption.asp
2. http://www.optiontradingtips.com/strategies/long-put-option.html
3. http://www.smartmoney.com/options/index.cfm?Story=pricing1111
4. http://www.valueline.com/edu_options/rep1.html
5. http://www.investorwords.com/4559/short_squeeze.html