Article in Examiner described covered call investing - see summary below. Any thoughts on how gains from this would be treated for tax purposes ?
If treated as capital gain what would the cost basis be ?
Millix
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.
If treated as capital gain what would the cost basis be ?
Millix
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.