There has always been some skepticism regarding the long-term profitability of a perpetual covered call trade. Some of these concerns are warranted but they can be minimalized as covered call investors learn more strategies for managing these long-term trades. One strategy for the perpetual covered call is a tax shelter. The media tends to overlook how taxes can be used as income shelters for covered calls especially a perpetual covered call setup for one year or longer.
It is important to keep a running tab on the capital losses and gains in your option portfolio. Remember, capital gains up to $3,000 in ordinary income can be offset by capital losses dollar-for-dollar. Your investing decisions should be made considering your total tax liability.
Here are some important concepts related to taxes and covered call trading:
- Option premium is not considered income until the option contract has ended by expiration, assignment or purchased to close.
- The IRS requires the option trader to net or offset capital gains from losses; your payback is lower taxes.
- There is a tax advantage of long-term capital gains for some taxpayers with a max tax rate of 25% on net capital gains; long-term is considered one year or more.
- Net capital losses, both long-term and short-term, can be used to reduce ordinary income as outlined by the IRS. The capital loss can be carried forward when you have more loss than allowed for the current tax year.
- When a call writer buys back a sold call at an amount greater than the premium received, the addition amount spent above the original premium is considered a tax loss (call buyback amount – call premium received = tax loss).
- Tax planning requires knowing where you are concerning taxes. You should always consult a tax professional before implementing new tax planning strategies.
So what does this mean to the perpetual covered call investor? If a covered call is written on a stock and the stock price exceeds the strike price, then the seller can purchase the call option to close the transaction (buy to close, BTC). The amount paid above the premium received on the call sold is a taxable loss. These taxable losses can be used to offset premium and capital gains from the option portfolio. Also, by utilizing the selling of calls for monthly income in conjunction with buying to close call options above the strike price can keep a stock open until it reaches long-term capital gains for tax advantages. You can also defer capital gains by selling call options into the next year as the transaction will not conclude until the end of the option.
Below is an example of an actual perpetual covered call trade on General Electric (GE). GE shares (1,000) were purchased on June 6, 2010 for a total cost of $16,017 including transaction costs. Each month, I sold 10 call options for monthly income. However, when the GE stock price exceeded the strike price I would buy-to-close those call options creating a tax loss rather than letting the shares be called away at the strike price. During this one year trade, I had total tax losses of $4,175.99 and net premiums of $5,624.67. I also had dividends of $400 and a stock capital gain of $1,973.48. The tax losses serve as a tax shelter as they will offset $4175.99 in current and/or future income. This must be looked at when making an investment decision when investing for perpetual income from covered calls. The tax advantage will serve to increase investing returns as you have less tax to pay when using them to offset capital gains or income.
For those who are skeptical of perpetual covered call trades, this may help them to better understand how to profit from these trades. The GE perpetual covered call netted a 25% return over the one year of the trade compared to only 17% for the S&P 500 during this time period.
Source: Get Rich Investments