Covered Calls (yes, again, but *twist)

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STC
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Covered Calls (yes, again, but *twist)

Post by STC » Mon Mar 18, 2013 1:27 pm

I am quite familiar with general opinions about covered calls, but I am thinking that I may be in a unique situation that makes it make sense during the course of this year.

My wife and I are buying a house this time next year. Most of the money for our 22% down payment is in bonds and will come from planned salary cash flow over the next 12 months. A small portion of that down payment ($30k - $40k) will come from a taxable equity account that is currently valued north of $120k. I am sitting on nice gains, and have no losses harvested to off-set those gains. Due to the size difference between what I need and the total value of the taxable account, I am not worried about volatility. If the market completely collapses, I likely wont buy a home anyway. At the same time, I will need to sell within the next 12 months...

With that backdrop, I have been considering selling covered calls against some ETF's in my taxable account. If I end up selling, then I have the down payment in cash (the end state anyway). If not, I collect a nice premium and try again. I was thinking about selling calls 1 month out, collecting a 1% premium (whatever strike that may be) each month till I am forced into cash.

Anyone see a problem with this?

livesoft
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Re: Covered Calls (yes, again, but *twist)

Post by livesoft » Mon Mar 18, 2013 1:32 pm

A 1% premium may not cover your costs. There may be no volume at the strike price you want. These are just the usual caveats with this strategy.
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STC
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Re: Covered Calls (yes, again, but *twist)

Post by STC » Mon Mar 18, 2013 1:36 pm

livesoft wrote:A 1% premium may not cover your costs. There may be no volume at the strike price you want. These are just the usual caveats with this strategy.


I noticed that with:

VV
IJS
VSS

However, plenty of volume with EEM.

And yes, I know VWO is a better emerging markets etf then EEM. I TLH'ed last year away from VWO and then emerging markets took off before I could get back. So I would likely focus on EEM and 5 contracts or so monthly.

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grabiner
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Re: Covered Calls (yes, again, but *twist)

Post by grabiner » Mon Mar 18, 2013 8:24 pm

There is no free lunch. If you could sell these covered calls at a fair price (no transaction costs), you would not improve your risk-adjusted return.

What you would do is change the tax characteristics of your return.

With some numbers:
You own 100 shares of an ETF which you bought for $60, strike price at $80, market price at $100, and you can write a call for a $2 premium. You need to raise $4000.

If you write a call option for $200 and it expires worthless as the ETF price remains $100, you have a $200 short-term capital gain on the call, and you need to sell 38 shares for a $1520 long-term gain. The tax due is $278, assuming a 25% rate on short-term gains and 15% on long-term gains.

If you sold the ETF instead of writing the call, you would sell 40 shares for a $1600 long-term gain. Your tax bill would be $240. Therefore, by writing the call, you paid an extra $38 of tax but saved $200 worth of stock, an effective tax rate of 19%.

If you write a call option for $200 and the ETF price drops to $70, you buy back the call for $1000, with an $800 capital loss. You now need to raise $4800, so you must sell 69 shares of the ETF for a $690 capital gain. The gain is offset by the loss and the $110 capital loss allows you to deduct $28 from your taxes, and you have $30 in leftover cash.

If you sold the ETF instead of writing the call, you would sell 62 shares for $70, for a $620 capital gain with $93 in tax and $40 in leftover cash. Therefore, by writing the call, you saved $121 in tax but lost $500 worth of stock and cash, an effective tax rate of 24%.

This suggests that the effective tax rate on the covered call as part of an investing strategy is fairly high.
David Grabiner

fatmike91
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Re: Covered Calls (yes, again, but *twist)

Post by fatmike91 » Mon Mar 18, 2013 8:53 pm

BAD SCENARIO: you write the call. Stock goes up toward strike price. lingers. Call is out of the money (you don't get called)...but you also don't sell the stock. Stock then declines. You are still holding it. So, yeah you collect a small premium, but you failed to sell the stock at a high when you want the cash to buy a house.

Why risk it? I'd just sell the stock now. If you have a gain, congratulations. Put some cash aside to pay taxes, and focus on finding a great house.

livesoft
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Re: Covered Calls (yes, again, but *twist)

Post by livesoft » Mon Mar 18, 2013 9:07 pm

I think you should try this strategy with EEM just for the experience. Then please come back to this thread and report your experience.

Can you tell that I like to use other people's money to get experience? :)
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happytrades
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Re: Covered Calls (yes, again, but *twist)

Post by happytrades » Mon Mar 18, 2013 9:18 pm

Investigate a collar. You buy a put to protect your downside and sell an out of the money call to cover the cost of the put. You have downside protection and still some upside potential.

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wshang
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Re: Covered Calls (yes, again, but *twist)

Post by wshang » Mon Mar 18, 2013 9:35 pm

grabiner wrote:If you write a call option for $200 and it expires worthless as the ETF price remains $100, you have a $200 short-term capital gain on the call, and you need to sell 38 shares for a $1520 long-term gain.

For index options, the 60/40 rule holds for long/short cap gains. This is an inherent favorable tax advantage with index options trading.
IRS Code Section 1256, which states that any gains or losses from the sale of these securities are subject to the 60/40 rule (60% of gains and losses are long-term and 40% are short-term, regardless of how long the securities are held).


As a practical matter, there are a couple of problems to consider (for example EEM):

1) EEM is considerably below its historic high. You could be selling relatively low because;

2) Implied volatility versus historic volatility does not imply a volatility skew in your favor;

3) You want to take advantage of 'mispricing' of options volatility.

It is far better to pick the ETF's rather than in your case, chose them for reasons other than theta decay or vega skew. Of course, all of this is utter heresy on this forum.
“. . . extraordinary wealth can be made by knowing the future" - Harry Dent

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hollowcave2
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Re: Covered Calls (yes, again, but *twist)

Post by hollowcave2 » Tue Mar 19, 2013 1:35 pm

With that backdrop, I have been considering selling covered calls against some ETF's in my taxable account. If I end up selling, then I have the down payment in cash (the end state anyway). If not, I collect a nice premium and try again


True, but you are forgetting that the equity ETF that is associated with the call may still drop in price and continue dropping such that the call premiums don't cover your loss in the ETF. If this happened, you would be better off simply selling the position. In other words, you still have downside market risk that you need to assess. You have a one year time frame, so one way to deal with this is to adjust your asset allocation to reflect the short term horizon. No one knows what will happen, so asset allocation is a way to deal with risk.

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