covered calls - tax treatment

Article yesterday in Examiner described covered call investing - see summary below. Any thoughts on how gains from this would be treated for tax purposes ?

Millix

--- from examiner Feb 25 ---


Covered call investing isn't much different to buying and selling stocks. The difference is that you enter into an arrangement to sell your stock at an agreed price (the strike price). In return, the covered call seller (yes, that's you) receives an agreed payment (known as the premium) from the person buying the call. Even if the option is never exercised, the seller keeps the premium.

Let's look at an example.
You own 100 shares of XYZ that you purchased at $40. You write an XYZ January 45 call at a premium of 3, raising $300 (100 shares x premium of 3) in option premiums.
Although your shares might be "called" (that is, you might have to sell at the strike price of $45 if it is exercised), the effective selling price would be $48 if that happened — made up of $45 (strike price) plus the premium of $3.

If nothing happens to the share price between now and January, the option expires worthless. You will have made a $3 return on a stagnating share price — a return of 7.5%. You still own the stock and can repeat the process monthly.
If XYZ becomes flavour of the month and rises to $45, the option will be exercised and your shares will be called away from you. Remember, though, the effective selling price is $48 if we include the premium. Only if the share price rises above $48 are you missing out. Combining the premium ($3) with the share price appreciation ($5) yields a profit of $8 per share, or 20%, compared to a yield of 12.5% without the call.
If the share price declines to $35, you will be down $5 per share. This unrealised loss, however, is partially offset by the $3 per share in premium you received for writing the call. So if you sell the stock your loss will only be $2 per share.
Covered call writing, then, involves forsaking price increases in excess of the option strike price. This is why the writer is compensated with the premium, giving him
(a) A guaranteed income irrespective of the performance of the stock.
(b) Protection (limited to the amount of the premium) from a decline in the stock price.

Hi Millisx- they would be reated the exact same as gains from share purchase & sale. When you buy call's & sell them (preferrably at a gain!), then the profit is subject to 20% Capital gains (less teh annual €1270 allowance).

ninsaga

Thanks for this - what did you think of the recommendation - oversimplification of the risks of derivative trading ?

Millix

it's a reasonable explanation of the basic mechanics i guess but it lacks analysis of why you'd want to do this.

if you want security (i.e. you're happy with lower returns in exchange for less volatility) then why own lots of stock in the first place? all this trading (on both sides, issuer and buyer) just lines the pockets of brokers, the exchange and the people offering courses and books on such investment techniques.

does it make any sense for an individual investor to spend time and money with insuring themselves against short term movements in share prices? i'd argue not.

also, i think the tax question might be more complex. for example, do you consider the 3 quid immediate profit when you sell the option (and why would it not be treated as income like dividends?) or do wait until the option expires before working out whether you've made a gain or a loss?

i remember a few years ago learning that when employees are given share options, revenue does not consider that the employee has benefited at the point of time when they are granted. it is only at the point of exercising the options that revenue consider that a profit has been made and that this profit is treated as income and not capital gain.