Seeking Alpha

Austinbroker's  Instablog

Austinbroker
Send Message
After finishing two Bachelor's degrees, Mathematics & Economics, I started a career in sales and eventually started my own consulting firm. There's an urban myth that Einstein said the most powerful force in the universe is compounding [interest]. A college class on theory of interest and an... More
My blog:
All About Interest
  • Options Trading Can Be Useful To Dividend Growth Investors 0 comments
    Jan 4, 2013 4:23 PM | about stocks: BBVA, INTC, JNJ, KO, MCD, MO, PEP, SLV

    The purpose of this article is to allow others to see my options results for the year in hopes that it may be helpful to them and to hopefully get some feedback from other dividend growth investors that are trading options.

    Let me start off by saying that I've learned quite a lot by trading options this year. This is the most I've ever used options trades. I closed out 21 options positions and earned more profit by trading options than I did from dividend income. This was partly due to a large speculative gain, $890, on iShares Silver Trust (SLV) earlier in the year.

    I am able to keep an eye on the market most of the day so that I can capitalize on large market movements. I still plan to use options trades in 2013 to either lower my cost basis or get paid a premium to wait for better prices. I will mainly only target companies I either already own or want to own in my dividend growth (DG) portfolio at a better price.

    Definitions

    For those of you not familiar with options trading, here are a couple of definitions:

    Put option - A put option gives the holder the right to sell a specific stock at a set price, the "strike price", on or before a specified date.

    Call option - A call option gives the holder the right to buy a specific stock at a set price on or before a specific date.

    The Trades

    If you want to see the specific trades for all of 2012, they are listed on my blog here.

    I made a total profit before commissions of $2719.

    I came up with total commissions of $469.26. This ate up 17.3% of my profits. However, I did include the 19.99 fee when shares get assigned for three different puts that were assigned to me. Without this $59.97, the commissions would have eaten up just 15.1% of the profits for puts that either expired or were closed out.

    My total profit after commissions was $2249.74. I made more in options profit than I did in dividend income! I don't know if that will continue but I do plan to keep my strategy of selling naked puts on companies I want to own anyways.

    As I mentioned, I was assigned shares 3 times at expiration due to selling puts. Let's look at how those turned out. Since I've already counted the income from selling the puts and subtracted the commissions from my profit I won't use an adjusted cost basis for a simple calculation of capital gains from these shares.

    I was put the following shares spending $6800:

    300 shares of Banco Bilbao Vizcaya Argentaria S.A. (BBVA) at $7/share

    100 shares of Intel (INTC) at $24/share

    100 shares of INTC at $23/share

    As of time of writing , 01/02/13, the price of BBVA was $9.55/share and the price of INTC was 21.35.

    The combined value of these companies is 7135.00, a profit of $335 if sold at the closing price.

    Now this is of course an unrealized capital gain since I haven't sold the stock and I know it doesn't take into consideration the adjusted cost basis so this is just an estimate. I do have a call option expiring January that will likely call away 200 shares of BBVA at a nice profit though. I also believe in INTC long-term and that it will recover.

    How to reduce commissions?

    Going forward, I would like to reduce the percentage of profits lost through commissions. I've outlined 6 ways in which I can accomplish this:

    1.) Selling multiple puts at once - While I could sell more than 1 put at a time, this one will be tough because I'm committing to 100 shares per contract that is sold.

    2.) Request better pricing - I've called E*TRADE and requested lower fees that are comparable to another brokerage firm. This is in process and I will post the results on my blog when it happens.

    3.) Use another brokerage firm - I've actually already signed up at ShareBuilder and plan to start contributing by February using that account. They do allow options and I'll be looking into pricing.

    4.) Wait for puts to expire - If I sell less puts that are speculative in nature then I would be more willing to ride out the put until expiration. When the put expires worthless there is no additional fee involving like when I have to buy back the put to close out the position.

    5.) Sell in-the-money puts - Basically this is selling a put priced around the current market value or less. While this strategy has a much higher change of getting put shares, the premiums paid are also much higher.

    6.) Sell longer dated puts - The longer until expiration, the higher the premiums you can earn. I do plan on selling some longer dated puts.

    Tax Consequences - applies only to the U.S.

    Buying options is a little different and I won't go into that now but if you are selling options, there are three things that can happen:

    1. They expire worthless on the expiration date

    2. They are exercised because they are "in the money"

    3. They are bought back prior to expiration to cancel out the option

    From a smartmoney.com article located here:

    "Option writers receive premiums for their efforts. The receipt of the premium has no tax consequences for you, the writer, until the option: (1) expires unexercised, (2) is exercised or (3) is offset in a "closing transaction" (explained below)."

    "When a put or call option expires, you treat the premium payment as a short-term capital gain realized on the expiration date. This is true even if the duration of the option exceeds 12 months. For example, say you wrote an April 5, 2011, put option at $25 per share for 1,000 shares of XYZ Corp. for a $1,500 premium. This creates an obligation for you to buy 1,000 shares at a strike price of $25. Fortunately for you, the stock soars to $35, and the holder wisely allows his option to expire. You treat the premium as a $1,500 short-term capital gain. Report it on Part I of Form 8949 as follows: Enter the April 6, 2010, expiration date in column (C), the $1,500 as sales proceeds in column (E), "expired" in column (F). If you wrote the option in the year before it expires, there are no tax consequences in the earlier year."

    "If you write a put option that gets exercised (meaning you have to buy the stock), reduce the tax basis of the shares you acquire by the premium you received. Again, your holding period starts the day after you acquire the shares."

    "If you write a call option that gets exercised (meaning you sell the stock), add the premium to the sales proceeds. Your gain or loss is short term or long term, depending on how long you held the shares."

    "With a closing transaction, your economic obligation under the option you wrote is offset by purchasing an equivalent option. For example, say you wrote a put option for 1,000 shares of XYZ Corp. at $50 per share with an expiration date of July 12, 2011. While this obligates you to buy 1,000 shares at $50, it can be offset by purchasing a July 12 put option for 1,000 shares at $50 per share. You now have both an obligation to buy (under the put option you wrote) and an offsetting right to sell (under the put option you bought). For tax purposes, the purchase of the offsetting option is a closing transaction because it effectively cancels the option you wrote. Your capital gain or loss is short term by definition. The amount is the difference between the premium you received for writing the option and the premium you paid to enter into the closing transaction. Report the gain or loss in the tax year you make the closing transaction."

    It's very important to know the tax consequences before you start options trading. I admit there were several things I did not know and I will be learning when I file taxes myself this year.

    Let me summarize the main points because this can be confusing:

    PUTS

    1. Selling a put that expires or is closed out (by buying back a put that you've sold) creates a short-term capital gain, no matter the holding period.
    2. Selling a put that expires or is closed out is only taxable in the year it expired or is closed out, not in the year the premium is received. Your profits (premiums received - premiums paid - commission costs) are taxed as short-term capital gains.
    3. Selling a put that gets assigned reduces the cost basis of the stock by the premiums received and capital gains treatment of that purchase begins on the date of assignment.

    CALLS

    1. If you sell a covered call and your shares are called away, add the premium minus commission costs to the sales proceeds. Your gain or loss can be short-term or long-term depending on the holding period.
    2. If you sell a call and it expires worthless or is closed out by buying it back, you are taxed as a short-term capital gain on your profit in the year of expiration, no matter the holding period.

    Conclusion

    Despite the tax treatment, I believe selling puts is a great way to generate extra income or reduce the cost basis on companies for DG investors. I would only recommend selling puts on companies that you either own or want to own anyways. I'm talking about the blue-chip, large moat companies that have long histories of paying and increasing dividends. Companies such as Johnson & Johnson (JNJ), The Coca-Cola Co (KO), PepsiCo Inc. (PEP), Altria Group Inc. (MO) and McDonald's Corp (MCD) to name a few.

    If you made it through all of that I would love to hear some feedback.

    I've also posted this on my blog located here where you can find all of my options trades as well as purchases for my DG portfolio.

    All of these trades are done in a taxable account since I don't qualify for a tax advantaged one.

    Disclosure: I am long BBVA, INTC, JNJ, MCD, MO, PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Themes: income-investing-strategy Stocks: BBVA, INTC, JNJ, KO, MCD, MO, PEP, SLV
Back To Austinbroker's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.