Selling Covered Calls and Naked Puts

[tutan]

I can't think of a good reason to buy a deep in the money long call except to gain big. So whoever shouldn't cash in too quickly. hmm...

 

[pb4uski]

Buying deep in the money covered calls on dividend stocks is not a strategy I've used before. Concept is interesting, so with a few bucks sitting idle I decided to use a portion to test the strategy.

I bought PFE, VZ and then a wild card AGNC (since it has monthly dividend) with short term 1/21/22 expiration.

PFE: $20 Strike / $48.02 Purchase / $28.07 Premium / $19.94 Net = 9.5% XIRR
VZ: $35 Strike / $55.15 Purchase / $20.19 Premium / $34.95 Net = 8.5% XIRR
AGNC: $5 Strike / $16.15 Purchase / $11.12 Premium / $5.03 Net = 28.9% XIRR

I went as deep as long as net was below strike (AGNC was as close as I could get). I'm expecting assignment as Ex-Div date comes around, but worse case I make a couple bucks. Best case I make a decent return on short-term cash.

I can't think of a good reason to buy a deep in the money long call except to gain big. So whoever shouldn't cash in too quickly. hmm...

From what I am reading that is the risk... that the call gets exercised just before the ex-dividend date so you don't end up receiving the dividend... you have a minor gain or loss for the difference between the net debit and the strike.

But my plan is to sell really long deep-in-the-money calls... Jan 2023... and what I am trying to get my head around to is why someone would buy a long deep-in-the-money call if they plan to exercise it within a month of so to get the dividend... if they want the dividend they can just buy the stock for what they pay out for the call plus the strike.

 

[aja8888]

From what I am reading that is the risk... that the call gets exercised just before the ex-dividend date so you don't end up receiving the dividend... you have a minor gain or loss for the difference between the net debit and the strike.

But my plan is to sell really long deep-in-the-money calls... Jan 2023... and what I am trying to get my head around to is why someone would buy a long deep-in-the-money call if they plan to exercise it within a month of so to get the dividend... if they want the dividend they can just buy the stock for what they pay out for the call plus the strike.

Except for some of us "income oriented" people, most option players are in the game to trade just the options.

I am guessing that the recent activity of using puts and calls by people like us (retirees) for income is a result of having no other low risk real income-producing alternatives (CD's gone, bond yields very low, etc).

 

[pb4uski]

Except for some of us "income oriented" people, most option players are in the game to trade just the options.

I am guessing that the recent activity of using puts and calls by people like us (retirees) for income is a result of having no other low risk real income-producing alternatives (CD's gone, bond yields very low, etc).

True, but I think the real option traders tend to focus on shorter term options... quite candidly, I don't see the play/benefit to the buyer of a long term call where the premium approximates the current price less the strike, but there must be some play because they do trade.

 

[aja8888]

True, but I think the real option traders tend to focus on shorter term options... quite candidly, I don't see the play/benefit to the buyer of a long term call where the premium approximates the current price less the strike, but there must be some play because they do trade.

I agree with you on the long dated option strategy as it seems like there must be more uses for it. I read a Seeking Alpha article recently where the author set up a retirement portfolio and as part of it sold a set of long term put options as an alternate source of income. If I can find the article, I'll post a link to it here.

Edit: I just found it: See Bucket #3 in the article:

https://seekingalpha.com/article/43...&utm_campaign=nl-must-read&utm_content=link-3

 

[MRG]

True, but I think the real option traders tend to focus on shorter term options... quite candidly, I don't see the play/benefit to the buyer of a long term call where the premium approximates the current price less the strike, but there must be some play because they do trade.

Poor man's covered call uses deep in the money leaps.

 

[bobandsherry]

From what I am reading that is the risk... that the call gets exercised just before the ex-dividend date so you don't end up receiving the dividend... you have a minor gain or loss for the difference between the net debit and the strike.

But my plan is to sell really long deep-in-the-money calls... Jan 2023... and what I am trying to get my head around to is why someone would buy a long deep-in-the-money call if they plan to exercise it within a month of so to get the dividend... if they want the dividend they can just buy the stock for what they pay out for the call plus the strike.

There is also a risk that dividend gets cut or suspended. Looking at past dividend payment history and available free cash flow are a couple good data points to also consider.

 

[pb4uski]

Fair points. A dividend cut would shave down the XIRR, but it would still be very good compared to corporate bonds of similar term and quality. In most cases the stocks that I would be buying would be higher yielding dividend aristocrats or similar like T, XOM, etc. so I think the risk of a big cut or suspension are very low.

 

[NW-Bound]

I can't think of a good reason to buy a deep in the money long call except to gain big. So whoever shouldn't cash in too quickly. hmm...

+1

A trader who buys an ITM call for the "poor man's covered call" strategy has the risk/reward partially cancels out by the OTM call that he sells.

But a holder of an ITM call who does not offset it with another trade is purely using leverage, in the hope of enjoying the potential stock gain while committing less capital than someone who buys the stock outright.

 

[rayvt]

I am guessing that the recent activity of using puts and calls by people like us (retirees) for income is a result of having no other low risk real income-producing alternatives (CD's gone, bond yields very low, etc).

"Everyone has a plan until they get punched in the mouth...philosopher Mike Tyson"

These are not low risk. They just seem to be. Funny thing is, you hit the nail on the head with the Tyson quote.

Nassim Taleb wrote about this kind of thing in his book Anti-Fragile.
"...treacherous conditions in which the benefits are small and visible -- and costs are large, delayed, and hidden. And, of course, the potential costs are much worse than the cumulative gains."

 

[rayvt]

quite candidly, I don't see the play/benefit to the buyer of a long term call where the premium approximates the current price less the strike, but there must be some play because they do trade.

It is always useful to look closely at something like this, to try to figure out what you are not seeing. In fact, this play is the opposite of the covered call play & that Taleb quote.

"the premium approximates the current price less the strike"

You see it, but you don't realize that you are seeing it! The restatement of this is "time value is nearly ZERO." You get all that time for almost free.

A deep in the money long dated call has delta close to 1.00.

Suppose you have a stock at 100 and you buy a 50 call with expiration 2 years out for $49. In essense, you now have 2X leverage for 2 years at a net cost of $1. You have essentially borrowed $50 for 2 years at an interest rate of 0.5%.
(Hard to go 50% ITM, though, usually more like 25%-35% ITM is the best you can find.)

Do this on a stock or an index that you feel sure will be higher in 2 years. An index is good because they are cash-settled.

 

[pb4uski]

I actually have some of those but not near as leveraged.... calls at 400 on SPY that expire 12/15/23 to try to capture the appreciation of the SPY between now and Dec 2023. It works for me because the money that I would have otherwise invested in SPY if I had just bought the SPY is invested various investment grade preferred stocks that yield about 5.5% so the combination of the two is similar to owning SPY on the upside but with limited downside risk.

I would probably sell the call about 6 months before expiry.

 

[JoshTrent]

I have put my toes in the fountain of Covered Calls.. I wrote a few yesterday on long positions I have held for a while (i.e. relatively low cost basis) for a week out, at OTM strikes I don't see them making, and I plan to hold them to expiry.

I understand that I may have left some money on the table, but at the same time, I didn't want to be too aggressive with my first encounter.

All of my sales were in a taxable account, so I have a couple questions (all refer to CC, but i assume it's similar when SP)..
- are the premiums realized when I sell the contract OR when the contract expires or is assigned?
- are taxes on premiums treated as CG? then ST or LT based on how long you held the contract?
- if I was in a trade and my underlying was called, would that gain/loss be taxed based on my lots FIFO? or based on the length of the contract? or is it automatically STCG?

Thanks!

 

[NW-Bound]

All of my sales were in a taxable account, so I have a couple questions (all refer to CC, but i assume it's similar when SP)..
- are the premiums realized when I sell the contract OR when the contract expires or is assigned?

Gain is realized when you close out the option by buying it back (this may be a loss), or when the contract expires worthless.

- are taxes on premiums treated as CG? then ST or LT based on how long you held the contract?

The option premium is always short-term capital gain/loss, even if it is held for longer than 1 year (LEAP options).

- if I was in a trade and my underlying was called, would that gain/loss be taxed based on my lots FIFO? or based on the length of the contract? or is it automatically STCG?

If an OTM call is assigned and the stock is sold, the option premium is added to the gain on the stock, and this capital gain is either short-term or long-term depending on when the stock was purchased. If you have more than 1 lot of stock, and the lots were bought at different dates, I don't know how the brokerage determines which lot gets sold due to the contract. You need to talk with your broker.

For ITM calls, it's more complicated. Having an ITM call on a stock may also affect tax treatment of the dividend of the stock.

For more info, see: https://www.fidelity.com/learning-center/investment-products/options/tax-implications-covered-calls.

I would not be able to write more than 2,000 contracts each year, if I had not done it on IRA accounts. The tax reporting would have driven me insane.

 

[finnski1]

I would not be able to write more than 2,000 contracts each year, if I had not done it on IRA accounts. The tax reporting would have driven me insane.

Agree. All my "trades" are done in IRAs as well and I have only a small amount each year.

 

[bobandsherry]

I would not be able to write more than 2,000 contracts each year, if I had not done it on IRA accounts. The tax reporting would have driven me insane.

Not really a problem. My broker reports the option activity and provides file to import. Simply import into my tax program and it's done.

 

[Sunset]

A long time ago, I sold some covered calls far out of the money, in a taxable account...
Sure enough the stock went up a LOT and they were going to be called

Since I didn't want to take the tax hit, I had to scramble to find $70K in the couch cushions to buy a bunch of that stock.

I changed my stock order to LIFO so the new stock would be taken and I'd have low capital gains.

Taught me a lesson to be very careful in my taxable account with this stuff..

 

[bobandsherry]

A long time ago, I sold some covered calls far out of the money, in a taxable account...
Sure enough the stock went up a LOT and they were going to be called

Since I didn't want to take the tax hit, I had to scramble to find $70K in the couch cushions to buy a bunch of that stock.

I changed my stock order to LIFO so the new stock would be taken and I'd have low capital gains.

Taught me a lesson to be very careful in my taxable account with this stuff..

Curious, why you didn't just buy the Call back instead of buying stock.

 

[Sunset]

Curious, why you didn't just buy the Call back instead of buying stock.

It was very early in my experience with options, so I didn't know how..

The funny part is on the last day , the stock dropped a little and so I ended up without the stock being called, and since I liked the stock, I left the new money in it.

 

[JoshTrent]

Gain is realized when you close out the option by buying it back (this may be a loss), or when the contract expires worthless.

The option premium is always short-term capital gain/loss, even if it is held for longer than 1 year (LEAP options).

If an OTM call is assigned and the stock is sold, the option premium is added to the gain on the stock, and this capital gain is either short-term or long-term depending on when the stock was purchased. If you have more than 1 lot of stock, and the lots were bought at different dates, I don't know how the brokerage determines which lot gets sold due to the contract. You need to talk with your broker.

For ITM calls, it's more complicated. Having an ITM call on a stock may also affect tax treatment of the dividend of the stock.

For more info, see: https://www.fidelity.com/learning-center/investment-products/options/tax-implications-covered-calls.

I would not be able to write more than 2,000 contracts each year, if I had not done it on IRA accounts. The tax reporting would have driven me insane.

Thank you for the info!

My goal is to produce income from my taxable account. I have long positions on dividend earners, and figured that I could sell CC's to increase their production. Now that I have the time on my hands and can pay more attention to them, I figure I will see trends to help my CC writing more effective.

I don't know that I will get into ITM writing, but I will keep in mind that those might affect taxes.

My Accounts are with FIDO, and they have always been helpful at tax time. However, I am also tracking all my trades in spreadsheets, that make a bit more sense to me.

Once I am comfortable and have established parameters for options trading, my plan is to unleash the buying power of my tIRA.

 

[NW-Bound]

Not really a problem. My broker reports the option activity and provides file to import. Simply import into my tax program and it's done.

Yes, I do have the transaction download with my broker and my tax program.

However, being a careful person and suspicious of software bugs, I always verify each transaction against my own records.

The gain from option premiums is always taxed as ordinary income, so there's no harm in selling options in an IRA account instead of an after-tax account. There's no need to have more work, if one can help it.

 

[NW-Bound]

It was very early in my experience with options, so I didn't know how..

The funny part is on the last day , the stock dropped a little and so I ended up without the stock being called, and since I liked the stock, I left the new money in it.

Yes, more than once I regretted that I was "losing" a good stock, and scrambled to undo or offset the covered call. This was either by buying a new lot (this works out better than buying back the call when the call still has a lot of time value left), or by selling a put at the same price but further out a week.

Then, when the stock came tumbling back down from the cloud, I kicked myself for not sitting still and let the event unfold to my advantage.

My option trading is a form of stock and market timing. And we all know that market timing ain't easy.

PS. Or a call that gets in the money can be rolled onto another call on a further out date. I have recently done more of this. When option buyers balk at paying more for a call further out in the future, I know that they no longer expect the stock to keep rising, meaning the stock is getting to the top end of its short-term range. Then, I will not roll the option, and just sit back to see what happens.

 

[JoshTrent]

Curious, why you didn't just buy the Call back instead of buying stock.

Hi @bobandsherry -
I am still wrapping my head around process of writing CC's, and I understand the concept of writing a CC to collect the premium - with the understanding that downside has unlimited risk and upside is capped by the strike.

Can you lay out an example of buying a call back? Would you typically do this if you wrote it OTM and it moved ITM at/prior to expiry?

 

[NW-Bound]

Hi @bobandsherry -
I am still wrapping my head around process of writing CC's, and I understand the concept of writing a CC to collect the premium - with the understanding that downside has unlimited risk and upside is capped by the strike.

Can you lay out an example of buying a call back? Would you typically do this if you wrote it OTM and it moved ITM at/prior to expiry?

Unlimited risk is only with naked calls. Because you hold the underlying stock, your risk is not higher than that of the stock holder who does not sell options.

The worst case loss is when the stock goes to 0. A buy-and-holder loses it all. You on the other hand has a little cash left from selling the option.

 

[JoshTrent]

Unlimited risk is only with naked calls. Because you hold the underlying stock, your risk is not higher than that of the stock holder who does not sell options.

The worst case is that the stock goes to 0. A buy-and-holder loses it all. You on the other hand has a little cash left from selling the option.

Great Point!

Most of the stocks I am writing on aren't the type to dive that deep, so I don't have the $0 concern.

FIDO limits me to only writing CC's, which is a nice failsafe. As I gain more experience, I may look for more freedom.