best method for protecting your profits.
Overcoming the Profit-Taking ProblemThe debate about whether or not it is conservative to use optionsdepends on the timing and motives behind the decision. Of course,buying options purely to speculate would be inconsistent with yourconservative goals.As a starting point in this discussion, we must identify the lowest likely price level for the stock. Support is a technical term, of course, andmost conservative investors do not use support and resistance as decision-making tools. However, an understanding of support level withinyour conservative risk profile helps you to coordinate option strategiesthat enable profit taking without needing to sell stock.At any given time, you probably have a fair idea of the support level forstock, based on recent historical price trends. This support level, atechnical tool, is by no means reliable or appropriate in your conservative, fundamentally based methodology. However, when you useoptions to identify short-term risk (as an avenue to identifying howand when to use options for taking profits, for example), it is alsoimportant to identify support level. The technical definition of support—the lowest price at which stock is likely to trade within the current price range—is the most reliable definition for the discussionthat follows.
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Realizing Profits Without Selling StockThe premise is that, as a conservative investor, you do not want to takeprofits just because the current price of stock is higher than your basis;at the same time, it would certainly be desirable to take those profitswithout selling stock. Given this premise, a few guidelines are valuablewithin your portfolio strategy:1. It is appropriate to use long puts to protect existing portfoliopositions. The long put, as insurance, represents a limited riskand ensures that current profitable prices are protected.2. It is also appropriate to use long calls only as a form of contingent purchase, when long-term options (LEAPS) are availableand when the purpose is to reserve the possibility of exercisingthose calls to purchase shares of stock. (See Chapter 6,“Alternatives to Stock Purchase,” for more in-depth discussionsof this strategy.)3. Long calls are further useful if and when prices of stocks youcurrently own have fallen rapidly due to marketwide pricedeclines; this presents a buying opportunity, but you may beunwilling to purchase additional shares as a means of exploiting the temporary condition. Calls can be exercised to acquireadditional shares to reduce your overall basis in the stock. Thisis a conservative strategy only if and when you want to acquireadditional shares of the stock.4. Short puts are useful as a form of contingent purchase (youhave shares put to you at the strike price if and when exercised)only when you would be pleased to purchase shares at the netprice (strike price reduced by put premium you receive). In thissituation, risk level should be thought of as the differencebetween strike price and price-support level, minus the net premium you receive for selling puts. Remember, support level isby no means an absolute value. You may employ certain fundamental tests such as profit and dividend history, tangible bookvalue per share, and other indicators to find what you considerthe stock’s support level. To find the net risk associated with
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short-put strategies, calculate the price level of exercise-adjustedprice (strike price less support level), and reduce this price bythe benefit of the net premium you receive. The net risk isdefined as follows:[S – L] – [P – T] = RS = strike price of short putL = support levelP = premium receivedT = transaction costsR = net risk level5. Short puts can be used in place of long calls when prices ofstock you own have declined and you expect near-term pricesto rise. This assumes you are willing to acquire shares at thestrike price if the put is ultimately exercised, based on the criteria in point 4 above.When is the decision to employ options speculative, and when is it a validconservative strategy? One consideration is whether or not you alreadyhave a position in the stock. As long as your purpose in using options isto protect profits, exploit price spikes, or average down your cost of stock,your conservative standards are compatible with using options in a variety of ways. If you use options to time market price movement in stocksyou do not own, it in only appropriate for contingent purchase strategies,qualified by the preceding conditions. Otherwise, using options just as ameans for profiting in stocks you do not own is speculative.
Further Defining Your Personal Investing StandardsIs it even necessary to protect profits, average down your basis, orexploit obvious market price spikes? The answer depends on your position, timing, and degree of advantage or disadvantage to a particularstrategy. For example, if you own stock you want to hold for the longterm, but a large correction recently occurred, how long will it take toget back to your original basis? It could take many months and, naturally, the concern is that it could take years. Meanwhile, capital is tiedup in a paper loss position.
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In this situation, options can be useful for managing and even reversingthe loss, erasing it and restoring a basic nearer to current market value.You can use short puts based on several assumptions. The first assumption is that the stock has reached its low and is going to begin rising; ifyour timing is correct, selling puts produces income but the puts willexpire worthless. That premium income reduces your basis in stock.Let’s look at an example based on actual historical market informationfor one of the stocks in our model portfolio: In January 2001, you purchased 100 shares of the Fannie Mae. At that time, you paid $85 pershare. Twenty-one months later, on October 22, 2004, share valueclosed at $67.65 per share. You sold a 65 put and received a premium of6.80 ($680). This reduced your basis in stock to $78.20.Because the short put could be exercised if the stock’s price continuedto decline below the put’s strike price, that strike price (net of put premium) has to be considered in the context of the continued long-termstrength of the company. It has to qualify as a long-term hold. Let’smodify our example: you originally bought 100 shares at $85 and 21months later, market value was $67.65. You sold two 40 puts at $6.80and received 13.60. This reduced your basis in the stock to $71.40 pershare (without calculating trading costs: $85.00 minus $13.60). Thestrategy works as long as you would be happy to increase your basis byan additional 200 shares of Fannie Mae. In the event of exercise, youraverage basis in the stock would be $67.13 per share, as shown below.This compares favorably to the current market price of stock as of thesample close: $67.65. The average basis in stock is calculated by addingtogether the net cost of all 300 shares, including reduction in basis fromput premium:Original cost, 100 shares
$85.00
Minus premium for selling 2 puts
–13.60
Net basis, original 100 shares
$71.40
Plus basis, 200 shares @ $65 per share
130.00
Net basis, all 300 shares
$201.40
Average ($201.40 ÷ 3)
$67.13
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Illustration for Fannie Mae (1)
PRICE
PER
SHARE
90898887868584838281807978777675747372717069686766656463626160
Original cost,$85 per share
Net basis, original 100 shares
-----------------------Current stockprice, $67.65------------------------------------------Two 65 putssold shortAverage net basis, 300 shares,if short puts are exercisedJFMAMJJASONDJFMAMJJASONDJFMAMJJASONDJFMAMJJASO2001200220032004
(1) Fannie Mae illustration based on historical prices and closing priceof stock and put premium values as of October 22, 2004
Figure 4–1 Short put rescue strategy.
This series of transactions is summarized in Figure 4–1.
When a Rescue Strategy Is AppropriateThis rescue strategy is appropriate only when (a) fundamental strengthcontinues to qualify the stock as a long-term growth investment, (b)you have capital available to purchase 200 more shares, and (c) you arewilling to have that amount invested in a single stock. The historicaldrop in price levels in Fannie Mae is a problem; however, if the fundamental value of this stock has not changed and you want to continue to
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hold shares, this rescue strategy helps reduce basis and acquire moreshares.If current market value were to rebound above the $70 per share level,you could sell the 200 shares acquired via short puts. Your average basisis $67.13, so a sale of 200 shares at $70 would result in a capital gain of$574 before transaction costs. But in reality, your original basis of the200 shares would be $85 per share on 100 shares and $65 per share onthe second 100 shares, plus a 4.40-point short-term gain on the putpremium:
Capital loss, original 100 shares ($85 – $65)
$–2,000
Capital gain, second 100 shares ($70 – $65)
+500
Profit from selling two puts @ 6.80
+1,360
Net profit or loss
$–140
The precise timing of gain recognition and the question of short-termversus long term varies on these three components. The point to beremembered, however, is that with a current market value in the stockof $67.65 per share, this series of transactions reduces the basis in the100-share position from $85 to $67.13, with a net $140 loss for tax purposes. In reality, you continue to own 100 shares with a basis of $67.13,and your $420 loss can be claimed this year on your tax return.Considering the dramatic two-year drop in market value of this stock,the rescue strategy worked well. You ended up with 100 shares withdramatically reduced market value and a small net loss reported, offsetby a paper profit. This is what makes the strategy both practical andprofitable when market value has declined in the stock.
Reverting to a Secondary StrategyA second possible strategy following the acquisition of stock throughexercised short puts is to revert to a covered call strategy. Given thesame circumstances as in the preceding example, you started out with100 shares you purchased at $85 per share. Average basis has been
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reduced to $67.13 per share on 300 shares, and the stock’s current market value is at $67.65 per share. Since your original position was limited to 100 shares, you may be willing to have 200 shares called away at aprofit. So, among various covered call strategies, you could write twocalls, each with strike prices of 70. In the event of exercise, 200 shareswould be sold at 5 points higher than your current basis, so your capital gain would be $1,000. In addition, you would keep the premiumincome from selling the calls. The 27-month 70 calls were valued at8.30 each, so this strategy would produce additional profits throughcovered calls of $1,660 for two covered calls.The outcome of this strategy is positive from all angles:1. You end up with 100 shares, but your basis is reduced from $85to $67.13.2. You earn premium from writing two short puts and two shortcalls, all of which is yours to keep.3. You have a capital gain on the 200 shares acquired and thencalled away.4. You come out of the series of transactions with 100 shares ofstock, which is unencumbered and can be held for long-termgrowth (but at 17.87 points lower basis than originally) or toprovide coverage for additional short call positions.The series of transactions detailed above resulted in an important netchange. You began and ended the position with 100 shares of stock, butyour basis was reduced by 17.87 points. Your realized net capital gainscreate a small loss, along with a reduced basis in stock. In this example,you did not need to sell your original 100 shares, but were able to employa combination of short puts and short calls to recover from the marketdecline. The risk in this situation was managed through the use ofoptions trades. The positions are justified as long as you have prequalifiedthe company, as always; the point is that options can be used effectively toadjust basis, manage volatility, and protect profits. In either outcome inthe preceding example, the put premium you receive reduced the basis instock so it was a sound fit for your conservative portfolio.
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If the puts in the preceding example were not exercised, you could havewaited out expiration, or you could have closed them prior to expiration.Once they were expired, you would have been free to write subsequentshort puts. However, if the price of stock had rebounded during the lifeof the put, you would not have needed or wanted to repeat the short putstrategy. If the puts’ value declined, you could have entered a closing purchase transaction. The net difference between your original sale and laterpurchase would have all been profit and, once the puts were closed, youcould replace the positions with new short puts, if desired.The greatest problem with strategies like this is the complexity of thetransaction. To execute a series of trades involving short puts and shortcalls, changes in basis and the number of shares owned, some conservative investors are understandably discouraged. It may require confidenceand skill to deal with the specific details. For example, if you want towrite short puts, your broker requires that you have funds on deposit topay for stock in the event of exercise: the cost of stock plus transactionfees, minus premium earned from the short sale. Considering that thepurpose in this transaction is to manage a decline in market value andto turn it into a profitable position, it is worth overcoming the initiallearning curve. However, you also should ensure that before you enterthe short positions, you fully understand the potential consequences, aswell as the benefits, in every possible outcome.
Managing the Inertia ProblemFor some conservative investors, the problem is not mastering the complexities of option trading; in fact, some may be quite comfortable withoptions and the various strategic possibilities they offer. A greater problem may be inertia.When market prices move quickly, the natural tendency is to close outpositions to cut further losses, or to become overcautious and fail to actwhen the timing is right. The panic reaction is untypical of conservative investors. You know the stock is a viable long-term hold, so you areunlikely to panic if prices drop out. You know that this temporary situation will turn around at some point in the future. Inertia, on the other
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hand, is more difficult to deal with. When prices fall unexpectedly, taking decisive action is a struggle between two forces: the desire to makesmart, well-timed moves and the fear that the entire market and itsconditions have changed and a more defensive posture is justified. Inhindsight, everyone knows that inertia is just another word for lostopportunity; but it is very difficult to act when the opportunity exists.
Inertia ManagementSome suggestions for dealing with the inertia problem:1. Set goals in advance. With specific goals set in advance, youimprove the clarity of your decisions. Sudden, even unexpectedchanges the market as a whole or in the profile of a particularstock prompt a specific and timely decision. Conservativeinvestors are not concerned with daily price timing but do wantto pay attention to fundamental changes. Price volatility oftensignals a change in the fundamentals, so your goals have to allowfor the unexpected. For example, if your criteria for holding astock require continued improvement in quarterly revenues,return on sales, capitalization ratios, increased dividend payments, and other useful indicators, what happens when one ofthose trends stops or turns around? If you decide in advance thatyou must sell shares at that point, take action. The goals shouldinvolve far more than questions of current price and profit andloss. As important as it is to your goals to make a profit, you alsoknow that—from a conservative viewpoint —holding shareswhen risks have increased can be dangerous as well.In setting action goals, selling shares does not have to be theonly possible decision. In reaction to changing news, you maydecide, for example, to take other action. Increased price volatility may prompt you to sell if you can break even or make aprofit, or to buy one put per 100 shares to provide downsideprice protection. A high market price condition along withchanged fundamentals may prompt you to sell a covered call forlimited downside protection or to sell and take profits, and then
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move capital to another issue. Selling shares is not the only possible way to cut losses; options can help you to adopt a defensiveposition while also preserving your long-term holdings.2. Follow your own rules without exception. Prearranged goals giveyou comfort and clarity, and programmed reactions offsetemotions. The emotional block to taking decisive action is acommon flaw in the market, and you can overcome this flaw byoperating from the base of your own rules. Once your rules areset and analyzed critically, follow them without fail, even ifyour instinct tells you to wait and see, or to take a differentaction. When prices become volatile, it is the worst time tolower your guard and speculate. The real test of conservatism ishow you act when prices are volatile and there is more to lose.3. Develop two-part strategies. What if prices rise? What if pricescontinue to fall? Plan your actions based on worst-case scenarios. You have a particular course of action if and when pricesrise in volatile times and a different course of action whenstock prices fall. Remember, volatility itself is what changesyour risk level, and you must identify an action plan. If thevolatility is temporary, you can use options to smooth out therough ride while expanding possible secondary actions if youlater decide the fundamentals have also changed. If thatchanged volatility is permanent, seek an exit strategy. If you cansell at a profit and the fundamentals have changed, take actionimmediately. If not, you may have to accept a loss, or you maybe able to use options to protect yourself against further lossesand to provide opportunities for developing a profitable situation in the near future.4. Consider closing positions when risk attributes have changed.Volatility is often more than cyclical market change; it may alsobe a symptom of a change in the stock’s fundamental profile,indicating the need for further investigation. When your stockhas been trading in a narrow price range and suddenly breaksout and behaves erratically, you must determine why. Is thevolatility occurring throughout the market? Is current news
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causing the change, and if so, do you expect the price range toreturn to normal levels? Does the volatility follow recent earnings reports, and is there anything in the operating results thatyou should act upon? If fundamental conditions have changed,then you may want to revisit your assumptions concerning thecompany; you may conclude that attributes have changed andthat you need to sell that stock.It may be worth redefining your investment policies on a conservativetheme. It is not realistic to expect to always make profitable decisions;but you do expect that by selecting stocks wisely, your portfolio willperform better than market averages. While options can certainly helpin this goal, it may be more prudent to sell shares that have become lesssafe. Your capital may serve you better elsewhere. The conservativetheme of your portfolio should not dictate profit levels, but youractions. By following those themes, you avoid the common probleminvestors face: ending up with a portfolio of stocks acquired above current market value. Inexperienced investors tend to take profits whenever they are available, so by selection, they end up with a portfolio full ofunderperforming stocks. This is contrary to any investor’s goals.Because you are a conservative investor, it is important to know notonly when to take profits, but also when to take losses.
Taxes and ProfitsThe various strategies you employ to either protect paper profits orminimize paper losses may be profitable or not, depending on your taxstatus. If a profitable or breakeven situation is calculated on a pretaxbasis, it may end up at a net loss after tax liabilities are calculated.To assess strategic decisions with tax liabilities in mind, several pointshave to be included in your analysis:1. Carryover loss status. As a planning tool, carryover losses areeasily forgotten or ignored. Many investors have fairly largelosses from past years that can be used to offset current-yeargains. If your carryover loss is substantial, you may absorb thatloss by taking gains this year that you might not have taken
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otherwise. As inconvenient as carryover losses are, they providea planning opportunity. For example, as long as you avoid the30-day wash sale rule, large realized profits can be absorbed bycarryover losses, and the current position can be replaced witha lower basis. However, if you use options to protect currentvalue in stock, you could jeopardize the tax advantage. Forexample, if you own appreciated stock, you can sell shares thisyear to offset a carryover loss. If you wait 31 days or more, youcan repurchase shares and establish the current price as yournew basis. If you also sell puts or buy calls to protect your current basis in the event of a price decline, it may be treated as arelated transaction: you may not be able to claim the loss onstock if you have opened option transactions as well. These socalled “offsetting positions” are complicated. If you sell in-themoney puts within the 30-day period—meaning the put islikely to be exercised—you may risk losing the right to claim aloss on the stock. The sale of stock and the exercise of the put(meaning a reacquisition of the same stock) could negate thesale under the wash sale rule.To be on the safe side, a true sale of stock should occur withoutany use of options. Wait the 31 days and repurchase stock, orsell in-the-money puts at the strike price close to your saleprice. When the put is exercised, reacquire the stock, discountedby the premium you received when you sold the put. Or, youcan simply wait the 31 days and buy the stock without usingoptions in the transaction.2. Your true effective tax rate. When you calculate the tax effect ofcapital gains on stock or options, be sure to include both federal and state taxes. Your “true” effective rate is the combined rateof both. The effective rate is defined as taxes on any earningsyou report within your effective tax bracket. For example, ifyour annual income places you in the 33 percent federal taxbracket, any additional reported income is taxed at that level.However, you may also be taxed by your state. For example, ifyour tax rate for state earnings is 8 percent, then your combined effective tax rate is 41 percent. You may need to makeadditional calculations. For example, while federal long-termChapter 4 Managing Profits and Losses
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capital gains rates are fixed at a lower rate, your state may notprovide any long-term gains provision.The adjustment could be complex. In calculating a long-termgain, for example, you may need to reduce the federal rate from33 percent to 15 percent but calculate the state tax based on thefull rate assessed. At the same time, you may have a federal carryover loss, but no corresponding loss (or a different one) onthe state level. To compare tax rules for each state, check theWeb site http://www.taxadmin.org/fta/rate/ind_inc.html.3. The timing of your profits and losses. Traditional tax planninginvolves preplanned timing of taxable gains and, equally important, of tax losses. You can time your profits and losses based onyour tax status this year. However, your priority in timing oftransactions should be set first on your conservative goals. Onlywhen it makes no difference should the tax questions come intoplay. For example, if a sale this year would create a net loss, butyou already have a large loss carryover, there is no tax advantage to selling shares before the end of the year. In this case, youcould buy puts to protect your current value and wait untilnext year, when you may need the loss. If the tax advantagenext year would be greater than the cost of buying the put, thenit makes sense to employ this strategy.To the extent that you can plan profits and losses to offset oneanother, you can minimize your tax liability. Tax avoidance islegal, but it requires planning and consultation with your taxadviser. Profits and losses can be offset based on timing of profitable sales with disposal of loss-status assets. Profits can also beoffset against carryover losses. In the past, stock profits andlosses could be offset against nondeferred gains from selling aprimary residence. Today, though, profits from selling your primary residence are tax-free up to $500,000 and cannot bedeferred. This is a great advantage, but timing and coordinationbetween residence sales and your investment portfolio providesno year-to-year planning advantage.4. Offsetting profits and losses in the same year. One of the mosteffective planning devices is to simply match profits against
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current-year losses. The outcome is to have no effect on youreffective tax rate. If your rate is close to the point where additional income would push your taxes into the next bracket, preplanning makes sense. If you intend to take profits, it may besmart to also dispose of underperforming stock. You gain twoadvantages by coordinating the timing of these transactions.First, you shelter gains by offsetting them with investment losses. Second, you dispose of stocks that have not performed asyou hoped. This is far more conservative than making decisionsin isolation. You may experience subsequent year swings inyour tax bracket and liability if you do not plan. For example,this year, you may sell several stocks and realize capital gains,which are taxed; and next year, you may sell several stocks thathave lost value, creating a carryover loss of limited year-to-yearvalue. By not planning ahead, you may create a problem foryourself. Not only do you face the possible jump in your taxbracket in the profitable year, but you may also create problemsby placing your investment losses into a single year without offsetting gains. While all of your gains are taxed in the yearreported, your maximum annual capital loss is $3,000. It makesno sense to create a carryover loss when, with some preplanning, you can time those losses so they can be used as offsets toreduce current-year tax liabilities.5. Unintended tax consequences. The tax rules for options-relatedtransactions are complex. For many individuals, the tax rulesare too complicated even without options, so many people whosimply buy and sell stocks, mutual funds, and real estate hiretax experts to help them comply with the law. When you addoptions to the mix, the complexity makes professional helpmore important than ever. Be sure your tax professional iscompletely knowledgeable in the area of tax rules for options.You must pay for the professional advice not only at tax seasonbut throughout the year. The complexity of rules, notably forin-the-money covered calls, can have consequences, includingthe loss of long-term capital gain status on your stock portfolio.Consult with your expert before making trades so that you
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understand the rules and know beforehand which types oftrades can cause significant loss of tax advantage.
Options Used for Riding Out VolatilityEvery investor has to contend with short-term price volatility. As a conservative investor, you focus on fundamental attributes of the companyand use short-term indicators only to test your ongoing assumptions. Ifthose assumptions change, then your hold strategy may become a sell.However, as long as you intend to continue holding stock, options canbe valuable in riding out short-term volatility as an alternative to profit taking in the traditional manner. With options, you can minimizeshort-term losses and even take profits while continuing to own sharesof stock.In the next chapter, the intriguing possibilities of the covered call strategy, including the special tax rules that apply to short options strategies,are explored in depth.
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5OPTIONS AS CASHGENERATORSCovered call writing is a conservative strategy. The key is inexploiting time value premium. For the strategy to make sense,your basis in stock must justify the short position, optionpremium must be adequate to justify the risk of exercise, andyou must know the tax ramifications before you open shortpositions. Tax rules for short options are odd and complex, butthey cannot be ignored.
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T
he covered call is among the most attractive of conservativeoption strategies. It provides an impressive rate of return whenproperly structured, and it does not increase the most commonforms of risk. In fact, market risk—your exposure to lost value in yourstock—is reduced with the covered call strategy.In this chapter, we explore the conservative possibilities of covered calls,starting with the underlying premise necessary to succeed with thisstrategy. We explore various outcome scenarios to form realistic judgments about when and if the covered call strategy makes sense. We perform our analysis with tax consequences in mind; for example, capitalgains rules for covered call strategies affect the decision and the timingof these short positions.One of the more intriguing strategies involving covered calls is the forward-and-up roll, a technique used to avoid exercise while increasingpotential profits in the event of future exercise. This idea works bestafter a run-up in stock prices that occurs after entry into the coveredcall strategy. We also examine using covered calls as a means for intentionally generating a sale of stock and at the same time creating moreprofit than would be possible through a straight stock sale.
The Covered Call ConceptNo strategy is completely risk-free, not even owning stock in wellmanaged, strongly capitalized companies. But in the case of a coveredcall, we seek to enhance our profits without incurring added market risk,and this is both practical and inevitable. For many investors, the lostopportunity risk is worth the additional income that covered call strategies generate. (Lost opportunity risk is discussed later in this chapter.)A covered call strategy has two elements. First is the ownership of 100shares of stock for each option to be covered; second is the short position
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in the call option. If you own 100 shares, you sell one call to achieve theone-to-one “covered” status. The call grants the right to the buyer on theother side of the transaction to buy your 100 shares (to call them away)at the set strike price at any time from the date of sale until expiration. Aslong as the current price of stock is below the strike price, the call shouldnot be exercised.Example: You own 100 shares of Pepsi. The current price is$48.48. If you consider covered calls with strike prices of 50,55, and 60, these positions are not exercised unless the marketvalue of the stock rises above those strike price levels beforethe call expires.
Who Makes the Decision?When you enter a covered call position, you are selling the call againststock you own. This means you give the right to exercise to the buyer,and that decision is entirely in the buyer’s hands. You are allowed tokeep the cash you receive upon selling the short call, whether the call isexercised or simply expires. You also continue to receive dividends during the period you are short on the call. The big question comes downto this: Is it worthwhile to risk having 100 shares of stock called away ifand when the stock’s price moves above the call’s strike price?To answer that all-important question, we analyze the transaction itself,review the yield outcomes based on all possible stock price movements,and analyze the after-tax yield from the covered call as well as potentialcapital gains on the called-away stock.The advantage to selling covered calls is that it produces instant cash.You are paid for selling the call. For example, if you can achieve animmediate 10 percent return on your stock by selling a call, is it worthwhile? The answer, of course, depends on your original purchase pricesversus today’s stock value as well as the potential call-away price. Theseelements determine your overall yield on the investment in