This Trading Strategy Could Save You Thousands in Tax Liabilities
There are a number of great benefits to the covered call options strategy. This approach to trading allows us to create reliable income from our stock positions while reducing the amount of risk that traditional investors face.
As a general rule, I expect to generate returns somewhere between 25% and 35% a year by continually setting up attractive covered call trades throughout the course of the year. Of course, the total returns vary depending on the market dynamics and the amount of risk taken, but this is a very reasonable annual target for this trading strategy.
In addition to generating tremendous returns, there are some very attractive tax advantages available to covered call traders. We’ll get into the details shortly, but first, a quick review of how the options strategy works.
The Basic Covered Call Options Strategy
To generate these strong returns, we start by buying quality stock positions that are fundamentally strong and are showing positive price action. We buy these stocks in 100-share lots and then sell one call contract for every 100 shares.
A call option gives the owner the right but not the responsibility to buy 100 shares of stock at a specific price within a defined time period. By selling these call contracts, we are giving someone else the right to buy 100 shares of stock from us at a specific price. We are getting paid to sell this right, which is how we generate the premium.
On the expiration date, if our stock is trading above the designated price (called a strike price) we must fulfill the obligation and sell our stock. But if the stock is trading below the strike price, we get to keep our stock and, of course, we get to keep the payment we received for selling the option contract.
Tax Treatment of Covered Call Positions
As a general rule, when you buy stock and then sell calls against that stock, the payment you receive from the option contract can be classified as a reduction in the net cost of the stock.
For instance, if you bought a stock at $49 and sold September $50 calls against the position for $3 per share, your net cost for the position is $46. If the stock remains below $50 and the calls expire, you should not have to pay taxes on the $300 of income ($3 per share) that you received by selling the call contracts. Instead, you now own shares of the stock with a lower cost basis.
Some traders continue to sell calls against their stock positions, continually creating income in their portfolio while slowly reducing the cost basis for their stock.
When the stock is eventually sold, the total amount of gains will be reported as taxable gains. But there is a definite advantage in deferring the tax liability until the position reaches long-term gain status, or simply into the next tax reporting period.
Long-Term vs. Short-Term Gains
The very best tax advantage for covered call trades is when you can continue to hold the original stock position throughout a full year. During this time period, we may sell four, five, or even six different contracts against our position.
If we sell options with a high enough strike price (so that we are not obligated to actually sell our shares), then we can continue to generate income all year long, and have this income taxed at the long-term rate.
For many investors, this can represent a savings of as much as 25% to 35% of the potential tax liability. This makes a significant difference when you look at the long-term return rate of your taxable investment account. The key here is making sure that you are able to hold on to your original stock through an entire 12-month period rather than selling with a gain before the 12 months are up.
There are also instances where it makes sense to use the covered call approach to defer a tax liability into the next year. Even if the trade is ultimately recorded as a short-term gain, deferring the trade into the next tax year can give you the use of all your capital for an additional 12 months versus paying the short-term tax gain in the current year and having a smaller capital base for generating income in the following year.
Although it never makes sense to stick with a poor trade simply for tax reasons, there are some tricks you can use with strong covered call trades to extend the life of the position and potentially hold for long-term gains.
A Creative Approach to Extending Positions
There are times when a covered call position trades higher than the strike price, and you can see that you are going to be obligated to sell your stock when the call contract expires.
If the stock is still trading in a healthy pattern and there are call contracts expiring further down the road that are attractively priced, you could elect to buy more stock at the higher price, and then sell additional calls against the new stock.
Technically speaking, you’re simply setting up a new covered call position with the same stock. But you may not realize that when the original calls expire, you can choose which block of stock to exercise them against.
So in this case, you could sell the second lot of stock that you purchased at a higher price and keep your original shares. In all likelihood, you will recognize an accounting loss on this second block (which is good for tax purposes), while at the same time holding your original position with a much lower cost basis.
Using this strategy allows you to keep your block of stock with the lowest cost basis, deferring your tax liability until you have held it long enough to qualify for long-term gains or into the next year, thereby deferring the tax liability to the next calendar year.
Some traders also choose to simply buy back their call contracts and sell contracts that have more time before expiration. This strategy works as well, but is often not quite as efficient. Many option contracts have a wide spread between the bid and ask prices (the price you must pay when buying versus what you are paid for selling). This causes “slippage” in the trade, which over time can cost you a good bit of profits.
Of course, before implementing these tax deferral strategies in your account, you should speak with your accountant about your individual situation. There may be extenuating circumstances with your financial situation — or in your local jurisdiction — that would be important to know before using this options strategy for tax purposes.
The bottom line is that covered calls can generate tremendous returns and are potentially much more tax-friendly than most other trading strategies.
As always, I would love to hear how you are implementing this strategy in your own account. Please send me an email at Editors@ProfitableTrading.com and let me know how you are putting this strategy into practice.