Richard Berger's  Instablog

In my articles about specific stocks, I often include a discussion on how to increase or create yield by the use of covered calls. The use of the covered calls generates cash income to add to your portfolio dividends or even create cash yield in stocks that pay no dividend at all. Properly used, they do so without adding any market risk at all. Covered option writing is such a prudent and low risk way to enhance investment yields that it is the only type of option contract permitted by law within IRA accounts.

There is one situation where the use of covered calls may add a substantial tax liability risk not present in the absence of writing the covered calls on your holdings. It is important for option writers to be aware of this situation which can actually cause an after tax loss greater than the income received by having written the calls. This potential arises when you write a covered call for shares in a non-tax deferred account on shares you hold which have a large gain reportable upon sale. For example, if you have a $100,000 capital gain on shares should they be called away at your strike price, the taxes on those gains may far exceed the call premium you received when creating the option contract. If that is the case, then you risk having less cash available to invest after paying the taxes then you had invested before the shares were sold. This decreases your future income stream that will produced by the re-investment of your after tax net funds. In situations where your present tax liability from selling your shares will exceed the value of the option premium received you should avoid writing a covered call which might trigger such a sale. The only exception is when you are prepared to sell the shares and pay your taxes on the gains anyway. When you plan to liquidate a holding and pay the taxes on your gains anyway, a covered call can help ease the net tax burden by generating some cash from the premium you can then use to help pay the taxes. This is an example where writing a deep in the money call might be advisable. You want the shares to sell (that is our premise in this example). A deep in the money call will insure the shares in fact do get called away. It will also usually generate the largest net option premium. Clearly, no added risk or burden accrues when the goal is the sale together with its tax consequences anyway.