5 Options as Cash Generators
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on the calculation of short-term or long-term capital gains holdingperiods. However, once you sell an in-the-money call, the whole question gets much more complicated. Here is a rundown of the tax rulesgoverning options:1. Rules for option buyers. If you buy options, the profit or loss caneither be long-term or short-term depending on how long youown the long option. The net amount is reported on ScheduleD in the year of sale. If the transaction is completed within 1year or less, it is taxed as a short-term capital gain or loss. If thetotal holding period was longer than 1 year, it is treated as along-term gain or loss.2. Rules for option sellers. The rules for option sellers are quite different. The payment you receive at the time of sale is not taxedat that point. The tax “event” occurs when the position is closedor canceled. If you sell an option in one year and it is closed inthe next, the tax is not calculated until the latter year. A “close”involves expiration of the contract, exercise, or a closing buytransaction.One important exception to the general rule governing short-term andlong-term tax rates is that if you keep a short call until expiration, it istreated as a short-term gain or loss, no matter how long the positionwas open. For example, you may sell a covered LEAPS call that does notexpire for 3 years. Upon expiration, the gain is considered short-term.If you close out the position with a buy order prior to expiration, it istreated as short-term if it was open for 1 year or less, or as long-term ifthe holding period went more than a year.If the call is exercised and your stock is called away, the gain is figuredincluding the premium you received from sale of the call along with thegain on stock. For example, if your capital gain was $2,400 and youreceived $830 for the option, all of the gain—$3,230—is treated in thesame manner. That treatment depends on the holding period of thestock and whether or not the call is defined under IRS rules as a “qualified” covered call. Nonqualified covered calls affect the calculation ofthe long-term gain holding period. As long as the option you sell is atthe money or out of the money, the holding period for your stock is not
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
affected or stopped. If the call is in the money and it meets the definition of qualified, the holding period is suspended. If it is nonqualified,the holding period is done away with and, for the purposes of calculating gain, the time limit begins anew.Example: You own stock currently valued at $75 per share.You sell covered call options with an $80 strike price. There isno effect on the calculation of the stock’s holding period,because the position is out of the money; the holding periodfor the stock’s eventual capital gain calculation continues torun. If you purchased the stock more than 1 year ago, youalready qualify for long-term capital gains treatment if andwhen the call is exercised. If your holding period is less than ayear, the time continues to run without interruption.Example: You own stock currently valued at $75 per share.You sell a covered call in the money (below the current valueof the stock). In this case, the status of long-term or shortterm gain is determined by the rules for qualification for thecall. If the call does qualify, the holding period of stock is suspended as long as the call position is open. If the call does notmeet the test of qualification, then your stock’s holding period is eliminated entirely and starts over. So, if you have ownedstock for less than a full year, selling an in-the-money call,even if qualified, is unwise; the time limit stops running aslong as the call is open, and if the call is nonqualified, you loseany time already accumulated toward the 1-year long-termholding period.A qualified covered call must have more than 30 days until expiration.In-the-money calls with fewer than 30 days to expiration are not qualified. For calls with expiration occurring more than 30 days, qualification depends on the stock’s closing price and on option strike pricelevel. This is where the calculation becomes complicated. Based on theprevious day’s closing price of stock at the time the call is sold, it is necessary to calculate the lowest qualified strike price. (Remember, as longas the call is out of the money, there is no need to qualify its status.There is no effect on calculation of holding periods.)
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Six Levels of Separation (of Your Money) for TaxesThe following applies only to in-the-money covered calls. There are sixseparate levels of calculation:1. The previous day’s closing stock price is $25 or less and the optionhas more than 30 days to go until expiration. A qualified coveredcall must be no lower than one strike price below the closingstock price, but no qualified call is counted if the strike price isless than 85 percent of the stock price. This is somewhat mindboggling, and the average investor has to wonder how such limitations were arrived at, what they are meant to achieve orprevent, and why the calculation has to be so complex. The purpose in limiting qualification is to apply special rules for “offsetting positions” in which risks are reduced so that tax benefitsand deferrals are minimized. The qualification price ranges ofcalls in this classification are summarized in Table 5–3.2. The previous day’s closing stock price is between $25.01 and$60.00, and the option has more than 30 days until expiration. Aqualified covered call must be no lower than one strike pricebelow the previous day’s closing stock price.3. The previous day’s closing stock price is between $60.01 and $150,and the option expires in 31 to 90 days. A qualified covered callmust be no lower than one strike price below the previous day’sclosing stock price, but not more than $10 in the money.4. The previous day’s closing stock price is between $60.01 and $150,and the option expires beyond 90 days. A qualified covered callmust be no lower than one strike price below the previous day’sclosing stock price, but not more than $10 in the money.5. The previous day’s closing stock price is greater than $150 pershare and the option will expire between 31 and 90 days. A qualified covered call must be no lower than one strike price belowthe previous day’s closing stock price.6. The previous day’s closing stock price is greater than $150 pershare, and the option expires beyond 90 days. A qualified covered
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 5–3 Qualified Covered Calls for Stock Prices of $25 or Below
Stock ClosingPrice
85%
Qualified Calls Price Range*
$25
21.25
21.25–24.75
24
20.40
20.50–23.75
23
19.55
19.75–22.75
22
18.70
18.75–21.75
21
17.85
18.00–20.75
$20
17.00
17.00–19.75
19
16.15
16.25–18.75
18
15.30
15.50–17.75
17
14.45
14.50–16.76
16
13.60
13.75–15.75
$15
12.75
12.75–14.75
14
11.90
12.00–13.75
13
11.05
11.25–12.75
12
10.20
10.25–11.75
11
9.35
9.50–10.75
10
8.50
8.50–9.75
$9
7.65
7.75–8.75
8
6.80
7.00–7.75
7
5.95
6.00–6.75
6
5.10
5.25–5.75
5
4.25
4.25–4.75
$4
3.40
3.50–3.75
3
2.55
2.75 only
2
1.70
1.75 only
1
0.85
1.00 only
* This range assumes that calls are traded in increments of $0.25.
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call must be no lower than two strike prices below the previousday’s closing stock price.The tax rules for writing in-the-money covered calls are clearly complex and potentially costly in terms of tax consequences. Since the longterm gain period can be suspended (for qualified calls) or eveneliminated and started over (for nonqualified calls), most conservativeinvestors find no justification in writing in-the-money calls. However,even beyond tax considerations, the question of a call’s status dictatesthat out-of-the-money covered calls make sense. Your advantage as aseller is found in time value premium.In conclusion, the conservative investor should seek out-of-the-moneycovered calls exclusively. This simplifies the tax calculations and conforms to the commonsense standards defining a conservative strategy.One exception to this general rule is that if you have large carryoverlosses, you may not be concerned with taxation of current-year capitalgains. Because annual capital losses are limited to $3,000 maximum, alarge carryover loss may be used to absorb current-year gains. So, evenif you lose long-term capital gains status for exercised stock, that largecarryover loss presents a planning advantage; you can engage in in-themoney covered call writing without worrying about long-term orshort-term restrictions.
Rolling Forward and Up—Exercise AvoidanceThe complexities of the tax rules are easily avoided by utilizing onlyout-of-the-money covered calls. For conservative investors, this makesgood sense even without considering how federal taxes affect the strategy. It can and does affect planning if you intend to create a forced saleusing deep in-the-money calls (“deep” means more than 5 points belowstrike price). Under the definitions in the tax rules, that would convertall stock sales to short-term because the options would be nonqualified.Rather than seeking forced exercise, most conservative investor prefer tokeep ownership of the stock and use options to maximize short-termincome, hopefully in a repetitive fashion. So, exercise avoidance is a farmore attractive strategy for most people. In some instances, a stock’s
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
trading range remains narrow enough that option profits can beachieved with little effort or lost opportunity risk; relatively low pricevolatility means there is little chance of exercise. However, a stock’sprice can exceed the strike price, which makes it a viable conservativestrategy to avoid exercise.Since covered call writers have to accept the possibility of exercise, whyavoid it? While exercise is a very real possibility, it is often preferable tokeep well-selected stocks in the portfolio and to take steps to (a) avoidhaving it called away, (b) be able to continue writing subsequent calls,and (c) in the event of exercise, maximize income from the transaction.All of this requires employing the rolling technique.
The Types of RollsIn a roll, you close out a current open position and at the same timeopen a subsequent position that has one of three possible attributes:1. A roll forward: The new covered call expires later than the oldcovered call but at the same strike price. Caution: If the stockprice moves above this strike price, you risk converting yourout-of-the-money covered call into an in-the-money call, so theentire tax picture of stock profits changes.2. A roll up: The new covered call expires at the same time but ata higher strike price. With this strategy, expiration remains thesame, but you “buy” another 5 points of profit in the event ofexercise. The difference of 5 points may be only 2 or 3 points ofcost, so if you expect the stock’s price to continue rising, losinga few points in the exchange of one option for another is not anegative in every instance. For example, the net difference inbuying out of the current position and opening the new one is2 points, but you gain 5 points in the higher strike price.3. A roll forward and up: The new covered call expires later thanthe old covered call and at a higher strike price. This is the mostdesirable rolling method. It is possible to execute a forwardand-up roll while still producing a net credit. This means morepremium income as well as a higher potential exercise price. By
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avoiding exercise, you gain more net income, and you also gain5 points (assuming the calls are trading within 5-point increments, as most medium-range stock priced calls do). You giveup more time in exchange.Example: You originally sold a Federal Express call with a strikeprice of 90 and expiring in January, 27 months away. At thattime, the stock was trading at $87.78 per share. You received$1,230 when you sold the covered call. Today, the stock hasmoved up to $92 per share, and you want to avoid exercise.If you exchange the January 90 call for an April 90 call, youwill receive a net premium because the later call has moretime value. However, because the new call is in the money,either you will suspend the long-term capital gain term or, ifthe new option is nonqualified, the stock’s status may returnto a zero count, meaning long-term capital gain status will belost. In the event of exercise within the term of the optionremaining open, all gain is treated as short-term.If you exchange the January 90 for a January 95 call, you gainthe 5 points in the event of exercise, which would yield anadditional $500. This move would not produce a credit, soyou would have to spend money to roll up.The most desirable strategy is to roll forward and up. Forexample, exchange the January 90 call for an April 95 call.This normally yields a net credit cash exchange, so you receivecash in the roll. At the same time, by closing out the originalposition, you create a current-year loss for tax purposes. (Ifyou had the position open for a year or less, it is treated as ashort-term loss, and if longer than a year, as a long-term loss).So, from a timing standpoint, you can create positive cashflow in one year accompanied with a tax loss and defer a gainuntil the following year by rolling to a different call.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
The Exercise Acceptance StrategyA final strategy worth mentioning is the exercise acceptance strategy.Most conservative investors are content to keep their long-term stocksand to use well-selected out-of-the-money calls to create additionalprofits along with downside protection. However, what if you would behappy to see your call exercised?Example: You bought shares of Federal Express at $72 pershare 2 years ago. That stock has current market value of$87.78 per share. You would be happy to sell today and take a15.78-point long-term capital gain. However, you could sell acovered call expiring in 27 months and gain even more.Today, the 27-month 90 calls sell for $1,230. If exercised, youcould keep the $1,230 and earn capital gains.Selling covered calls is a profitable alternative to simply owning stock.You can also force exercise by intentionally writing in-the-money calls.However, because this ensures the loss of long-term status of capitalgains when exercise occurs, the strategy has to be studied on an aftertax basis. When you have a large carryover loss from previous years, itcould be an effective way to create large option premium gains andabsorb unused carryover. Your annual net-loss deduction is limited to$3,000, so if you have a $30,000 carryover, it would take 10 years to useit up. It is desirable to absorb that loss as soon as possible; so in thiscase, creating a large gain in stock and options by writing deep in-themoney covered calls (virtually ensuring exercise) would be beneficialbecause the loss of long-term status is sheltered by the carryover loss.
Remembering to Limit Yourself to Conservative StrategiesWe consider covered calls a conservative strategy because no increasedmarket risk is involved. The alternative, simply owning shares of stock,has an inherent market risk, and discounting the basis by generatingcall premium reduces the basis in stock, thus reducing the net marketrisk. Covered call writing does involve lost opportunity risk, but inreviewing likely scenarios for a number of stocks, we know that such
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lost opportunities occur in a minority of cases, while consistent highreturns from covered calls are certain.In the next chapter, we explore interesting ways to use options as analternative to the outright purchase of shares of stock. Contingent purchase strategies make options powerful tools, especially during volatilemarket periods.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
6ALTERNATIVES TO STOCKPURCHASEMost investors start by looking for stocks they want to buy. Butwith options, there are many other ways—safer ways—to enterthe market. Contingent purchase using either long calls or shortputs is a powerful weapon in your strategic arsenal. Options canalso be rolled forward to avoid exercise or applied to recoverpaper loss positions. This chapter explores these ideas anddemonstrates how the ratio write can be converted into a riskfree conservative strategy.
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O
ptions open up a range of contingent strategies. Covered callsare interesting because they are the ultimate low-risk form ofcontingent sale. If and when exercised, the covered call isdesigned to produce current income consisting of both dividendincome and call premium.Contingent sale—represented by the covered call strategy—is the mostconservative use of options. However, you can also use options to leverage capital in several forms of contingent purchase. As an alternative tobuying shares of stock, you can either buy calls or sell puts with theintention of acquiring stock before expiration. This strategy is appropriate when the market is volatile or when marketwide prices fall significantly. You recognize the buying opportunity, yet you do not wantto risk capital on stock that might continue to fall even more.Because time is invariably an issue, LEAPS options are more likely towork in contingent strategies. The ability to leave positions open for aslong as 3 years makes LEAPS well suited for this range of strategies,whereas traditional listed options do not survive long enough for contingency to mature. The risks are simply too great that the option’s lifewill end before stock prices move adequately. This is especially truewhen you employ contingent strategies with long calls.
Leverage and OptionsThe contingent-purchase strategy is based on the assumption that anumber of conditions exist at the moment:1. The market is volatile; prices are down. The most likely marketcondition for contingent purchase is when prices have moveddownward or are highly volatile. You want to be in the market butat you hesitate to take equity positions, fearing ongoing volatility.
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The dilemma is a combination of (a) volatile conditions and (b)concern that you will lose opportunities if you don’t act now.2. You have capital available to open option positions. You musthave capital available either to purchase calls or to leave onmargin in the event that short puts are exercised. Looking tothe future, if you do decide to exercise long-call positions, youneed capital to complete your purchase as well. So, on the longside, you need to be able to buy calls—preferably in several different stocks—and later, to exercise. On the short side, you willbe required to deposit funds to buy stock (equal to the purchase price minus put premium you earn or, on margin, a portion of the purchase price, often one-half). These requirementsnaturally limit the extent of contingent purchase in which youcan afford to engage at any given time.3. You want to open contingent purchase positions in several stocks.The importance of diversification as a conservative model cannot be overemphasized. The basic theory behind contingentpurchase is that you do not know whether a particular stockwill rise or fall in the future, so you select stocks that meet yourfundamental criteria, and you open contingent purchase positions in that range of stocks. If you can afford to engage in contingent purchase on four or five stocks at the same time, youincrease your chances that they will end up being profitabledecisions. The essential starting point is that stocks you pickmust be stocks you would want to purchase if you were simplybuying shares. In any contingent-purchase strategy, you limityour activity to stocks that meet your conservative standardsbased on fundamental analysis.4. You believe that contingent purchase—given current circumstances—is an appropriate conservative strategy. This strategy,like all market strategies, must be assessed in context and aspart of a larger portfolio strategy. It is inadvisable to place all ofyour capital in options as part of a contingent-purchase strategy; your conservative portfolio should contain a foundation ofstrong growth stocks. Contingent purchase can be used to fix
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the price of additional shares of stock you already own or toensure your right to buy shares in new stocks if and when pricemovement goes in the right direction. But given market conditions and your personal rules for picking stocks, the underlyingissues have to be appropriate. If you select stocks for contingentpurchase based only on option pricing, you violate the basicrules for portfolio management. Conservative investing isalways based on equity value of the stock, and options are considered only as a secondary possible strategic means for acquiring shares.
Applications of Contingent-Purchase StrategiesContingent purchase is a way to fix the price of stock if and when youdecide to buy shares (in the case of calls) or if stock is put to you (in thecase of short puts). In either case, the basic rules remain:1. You would be pleased to acquire stock at the indicated strikeprice.2. You can afford to buy the stock.3. You have performed fundamental analysis and found the company suitable.4. The contingent-purchase strategy is appropriate, and you arecomfortable with it as an alternative to simply buying shares atthe current price.Just as any options strategy is wrong when based solely on option premium levels, using contingent purchase without intending to buy stockis wrong as well. Contingent purchase is appropriate only if you intendto buy shares, and your purpose in employing the strategy should be tolimit current risk and not to incur more risk. If you are following fourstocks that meet your criteria, but you are not sure that all will increasein value, contingent purchase allows you to leverage capital and limityour risk exposure. Even if only some of those stocks increase in value,you can profit from the overall contingent-purchase strategy. By fixing
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
premium prices, you keep purchase as one possible outcome withoutundertaking excessive market risk. You may exercise long calls (or haveshort puts exercised), the options can expire worthless, or the positionscan be closed before expiration.Contingent-purchase strategies require watching so that you knowwhen to act and when to wait. This does not mean you have to trackprices on a daily basis, but frequent monitoring can help you to timesubsequent decisions to maximize profits or to reduce undesired losses.Depending on the contingent strategy you employ, time may work foror against you. The use of LEAPS makes the range of contingentpurchase strategies realistic, and working with options lasting as long as36 months gives you a lot of flexibility. In the market, 36 months is avery long time and a lot can occur in that period. If you look back overthe last three years and review the changes in market conditions andprices of individual stocks, you will appreciate the potential of longterm contingent purchase investing.Later in this chapter, we discuss how even a long position’s cost can bemitigated with offsetting long-term short positions. Given the right circumstances, you may recapture the entire cost of the long positionwithout incurring additional risk.It is risk, when all else is considered, that ultimately determines whetheror not you employ contingent-purchase strategies. No matter howprofitable and safe a strategy seems to be, it has to work as a good fit foryour conservative profile. This limits the kinds of strategies you will bewilling to use. Option strategies come in all shares and sizes, and manyare highly speculative.If you pick options incorrectly or ignore the underlying risks, thenusing option strategies simply won’t work for you. But the contingent-purchase strategies are sensible and conservative, assuming thefollowing:• The fundamentals of the underlying stock meet your standards.• You consider the strike price a good price for the stock.• The funds are available to open positions and, later, to exercise.
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The Long-Call Contingent-Purchase StrategyThe first contingent strategy involves buying calls instead of stock. Thiswould be a speculative move if the only purpose was to create profits incall premium. However, as long as your intention is to buy shares, thisstrategy fixes your future purchase price at the strike price. If you buy callsin several stocks and only some increase in value, you should exercisethose calls only on profitable positions. Contingent purchase limits yourcapital risk. For example, if you spend $500 on call premium and the stocklater falls 15 points, you can never lose more than your $500 investment.However, if you had bought 100 shares of stock, you would suffer a loss of$1,500. So, the primary advantage of the long-call contingent-purchasestrategy is limitation of risk. Its primary risk is loss of value, notablytime value.If you buy LEAPS calls with a long time until expiration—which isessential in order for this to qualify as a conservative strategy—you payfor the time value. We demonstrate later in this chapter how you canmitigate the long-call cost. For now, the question of whether the contingent purchase is worthwhile is determined by (a) call premium, (b)strike price of the underlying stock, (c) time until expiration, and (d)your desire to fix the price for possible future purchase. One of themore difficult situations occurs when you know that the current priceof stock is attractive, but you either cannot afford to buy or are concerned about short-term volatility. Buying LEAPS calls as a contingentpurchase strategy overcomes this dilemma.
Diversifying Exposure with Several Stocks in PlayThe strategy should involve several different stocks. This diversifiesyour exposure in a long-option position, and the very reason you areconsidering contingent purchase is that you do not know what futureprice levels will be. So using several well-selected stocks make sense aspart of a coordinated strategy.Here is how a contingent-purchase program might work using longcalls: we review our 10 model portfolio stocks. Table 6–1 summarizesthese stocks with available LEAPS calls.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 6–1 Stocks for Contingent Purchase Using Long CallsName ofCompany
Symbol
CurrentPrice*
Clorox
CLX
$55.91
Strike prices 0/70/xxCoca-Cola
KO
XOM
FNM
FDX
GD
JCP
PEP
WM
XRX
xx
5.10
2.30
xx
2.55
1.05
0.25
4.00
2.15
1.15
3.10
1.45
0.60
4.50
2.70
1.60
6.20
4.30
2.85
8.30
—
4.80
8.20
5.90
—
12.30
10.10
8.10
9.90
5.60
2.95
13.90
9.60
6.40
3.90
2.15
—
5.70
—
2.50
2.90
1.20
0.35
4.30
2.30
1.15
2.55
1.10
0.40
3.10
1.65
0.80
1.75
0.80
0.30
2.55
1.60
0.90
$38.43
Strike prices 40/45/50Xerox
—
$48.48
Strike prices 50/55/60WashingtonMutual
2.85
$38.20
Strike prices 40/45/50Pepsi Cola
3
$100.01
Strike prices 100/110/120J.C. Penney
2
3
$87.78
Strike prices 90/95/100GeneralDynamics
1
2
$67.65
Strike prices 70/75/80FederalExpress
1
$ 48.70
Strike prices 50/55/60Fannie Mae
January 2007 Calls
$ 38.90
Strike prices 40/45/50ExxonMobil
January 2006 Calls
$14.32
Strike prices 15/17.50/20
* Stock prices and option premium values based on closing prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).
The table lists a range of possible long calls. Two possible future datesare selected for all five stocks based on our October 22, 2004, reviewdate: January 2006 (15 months in the future) and January 2007 (27months out).If you bought one call for each stock, the overall price would depend onthe proximity between current market value and strike price. If youcompare the three strike prices selected for each stock to current market
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price, you can see how these values change. The first selection in eachtarget expiration is at or near the money, and the second and third strikeprices are farther out of the money. If you decided to buy one call foreach stock given these differences, your total cost would be as follows:1January 2006At or near the money
$4,390
One strike priceincrement up
2,455
Two strike priceincrements up
1,120
January 2007At or near the money
$6,375
One strike priceincrement up
4,140
Two strike priceincrements up
2,840
This cost summary shows how time value interacts with the proximitybetween current value and strike price. While you can vary the selectionof calls for each stock, our illustration makes the point. To buy a singlecall for each of the five sample stocks, you would pay the amountsshown. The calls at or near the money have the greatest potential forprice appreciation, so the premium costs are higher as well.
1 Note: Not every call has an available listing on any given close, so we estimated some values
in calculating these costs. We estimated the value of a January 2006 Clorox call at 1.00,although no such call was listed as available; and we calculated 0.50 value for a third call,although we only analyze two calls for Clorox. For 2007, we estimated a third-levelClorox call at 1.00. For Fannie Mae’s 2007 call with 75 strike, we used 6.00 to approximate the value because no such call was listed on the close. We used 2.00 for the FederalExpress 100 call expiring January 2006. Finally, we estimated two values for the J.C.Penney 45 calls that were not available on the close: 1.00 for the January 2006 call and3.00 for the January 2007 call.