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Option Trading 101: Looking Under the Hood of Covered Calls

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July 15, 2012

We shed some light on 3 features of this basic options strategy: selling stock, collecting dividends, and limiting taxes.

What draws investors to a covered call options strategy? Giving someone the right to buy your stock at the strike price in exchange for a few more greenbacks, baby. Covered calls are potential income earners on stocks you already own. Of course, there is no free lunch; your stock could be called away at any time during the life of the option. Selling or “writing” covered calls has many potential uses besides just being a way to potentially generate income that many investors don’t fully realize. Let’s take a look.

1. Exit a long position.

What may be one of the most underutilized ways to sell your stocks is by using a covered call strategy. If you already plan to sell, you might as well consider taking advantage of the potential to receive some additional income for your efforts.

Here’s how it works: Let’s say that XYZ stock is trading at $23 a share, and you want to sell your 100 shares at $25 per share. Sure, you could probably sell your XYZ shares right now for $23 per share in your brokerage account, but you could also sell (write) a covered call with your target price (strike price) of $25 a share.

If you sell the call, you’ll receive cash (premium), which is immediately deposited into your account (less any commissions and contract fees). The cash is yours to keep no matter what happens to the underlying shares. If XYZ rises above $25 or higher before the option expires, you’ll likely be assigned on your short option and your shares of XYZ will be called away from you at the strike price. In fact, that move fits right into your plan. You received premium for selling the call, and you also made an additional 2-points (from $23 to $25) on the stock. As desired, the stock was sold at your target price (i.e. called away from you) at $25. If the stock goes higher than $25, you made what you wanted, but not a penny more. After all, you agreed to sell XYZ at the $25 strike price. You pocketed your premium, and made another 2 points when your stock was sold. But you won’t participate in any stock appreciation above the strike price. Also, keep in mind the transaction costs (commissions, contract fees and option assignment fees) will reduce your gains.

ON THE OTHER HAND— In our example, although you would like to sell XYZ at $25, it’s possible that the stock price could fall from $23 to $20 or even lower. In this case, you still get to keep the premium you received and you will still own the stock on the expiration date, however, instead of the 2 points you had hoped to attain, you’re now looking at a potential loss, (depending on what price you originally bought XYZ at). In other words, there is some downside protection with this strategy, but it is limited to the cash you received when you sold the option.

HINT— Many options traders spend a lot of time analyzing the underlying stock in an effort to avoid unwanted surprises. They use that research to try to improve the odds that they choose stocks that won’t suffer a serious, unexpected price decline. Keep in mind no matter how much research you do, surprises are always possible.

HINT— Any time your covered call option is “at the money, or in-the-money,” your stock could be called away from you. And the deeper your option is in the money during the lifetime of the option, the higher probability that your stock will be called away from you, and sold at the strike price.

KEEP IN MIND— If your option is in-the-money by even one penny when expiration arrives, your stock would very likely be called away.

The Basics

Try the online Options: Covered Calls course. Log in to your account at tdameritrade.com Then go to: Education > Courses > Options: Covered Calls

2. Sell covered calls for premium, potentially continue to collect dividends and capital gains.

Selling covered calls can sometimes feel like you’ve made a triple play. After you sold a covered call on XYZ, you collect your premium and you can still continue to receive dividends and capital gains on the underlying stock unless the stock is called away. That’s the good news.

ON THE OTHER HAND— The option buyer (the person who agreed to buy your option) is not dumb. He or she may also want that dividend, so as the ex-dividend date approaches, the chances that your stock will be called away from you increase.

HINT— The option buyer (or holder) has the right to take that stock away from you anytime that the option is in-the-money. You still keep the premium and any capital gains up to the strike price, but you could lose out on the dividend if the stock leaves your account prior to the ex-dividend date.

HINT— Not surprisingly, some option buyers will exercise the call option prior to the ex-dividend date to capture the dividend for themselves. And if the option is deep in-the-money, there’s a higher probability the stock will be called away from you before you get to collect the dividend. Anytime you sell a call option on a stock you own, you must be prepared for the possibility that the stock will be called away. When you sell a covered call, you receive premium, but you also give up control of your stock.

KEEP IN MIND— Only options that are in-the-money would likely be exercised to collect the dividend.

3. Potential tax advantages in selling covered calls.

There may be tax advantages to selling covered calls in an IRA or other retirement account where premiums, capital gains, and dividends may be tax-deferred. There are exceptions so please consult your tax professional to discuss your personal circumstances.

Now, if the stock is held in a taxable brokerage account, there are some tax considerations. For example: Let’s say in November you have potential profits on XYZ stock, but for tax purposes, you don’t want to sell. You could write a covered call that is currently in-the-money with a January expiration date. Special rules apply to calls that are written “deep in the money” so please consult your tax professional to discuss your personal circumstances and the special rules.

If all goes as planned, the stock will be sold at the strike price in January, in a new tax year. Remember, you’re always accepting the risk, no matter how small, that your option will be assigned sooner than you planned. You could even be assigned on that in-the-money call the day after you sold it. The result could be that you sell the stock and take a profit in the very year you wanted to avoid. One way to reduce that probability but still aim for tax deferral is to write an out-of-the-money covered call.

FOR EXAMPLE— Let’s say in November you have potential profits on XYZ stock, but for tax purposes, you don’t want to sell. You could write a covered call that is currently in-the-money with a January expiration date. If all goes as planned, the stock will be sold at the strike price in January, in a new tax year. Remember, you’re always accepting the risk, no matter how small, that your option will be assigned sooner than you planned. One way to reduce that probability but still aim for tax deferment is to write an out-of-the-money covered call.

ON THE OTHER HAND— If the stock falls rather than appreciates, you will likely still be holding the stock, and the call option will expire worthless. In this example, you could always consider selling the stock, or sell another covered call. Nevertheless, a risk of hoping to get assigned on a covered call is that the underlying stock may fall and never reach your strike price, a scenario you must always anticipate.

HINT— Given a choice between paying taxes on a profitable stock trade and paying no taxes on an unprofitable stock trade, most people would rather pay the taxes. But that is a choice only you can make.

HINT— If you believe that the benefits of selling covered calls outweigh the risks, you might look for stocks that you consider good candidates for covered call writing. A buy-write allows you to simultaneously buy the underlying stock, and sell (write) a covered call.

KEEP IN MIND— You will likely pay two commissions, one for the buy on the stock and one for the write of the call. The key to avoiding the misuse of basic options strategies such as covered calls is education, research, and practice. Remember, any options strategy can only be right for you if it is true to your investment goals and risk tolerance.

Covered Calls At a Glance

Track the underlying stock and your options position—such as a covered call—on the thinkorswim® trading platform. Log in to your account at tdameritrade.com and launch thinkorswim. Then click the “Analyze” tab > Click “Add Simulated Trade” > Add the desired position > Click “Risk Profile.”

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FIGURE 1 Sample trade shows purchase of 1,000 shares of stock and sale of 10 calls. This example does not include transaction costs. Investors must consider the effects of transaction costs before placing options trades. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. For illustrative purposes only. Past performance does not guarantee future results.