Make the Right Call With Covered Calls

Many people think selling covered calls makes no sense. After all, why cap the upside on a stock that you're holding? However, using covered calls is often a very desirable strategy. Let's look at under what circumstances and why. First, suppose that you're long on a stock that's doing so well that it's already approached analysts' price target for the current year's end. You're sitting on a large taxable gain, but perhaps you haven't held the stock for more than a year (which would allow you to pay a lower long-term capital-gains tax rate on your profits). In such cases, it might seem desirable to hang onto the stock. However, companies that have nice run-ups often suffer big pullbacks. Selling your shares now would eliminate such downside risk, but would also trigger a large tax bill -- perhaps at your highest marginal rate. Cashing out now would also remove any chance for larger gains down the road, or for attaining more-favorable tax treatment after you'd held your shares for more than a year. In such circumstances, writing covered calls could be the answer. Let's use my old No. 1 holding, Tractor Supply Co. , as an example of how to do this to your advantage. How I Harvested Gains on Tractor Supply Co. I bought TSCO in summer 2017 after the stock fell from around $97 a share to below $50. TSCO's price-to-earnings ratio at that time dropped to 15x vs. an historical average of 23.4x, while its yield rose to 2.1% -- double the company's 1.05% post-2010 average. Clearly, Tractor Supply shares offered outstanding value at the time, and by January 2018, the stock had rebounded to about $84 a share. That was close to my price goal, but my shares were still far from being considered long-term holdings for tax purposes. So instead of dumping the shares, I sold a bunch of covered calls at strike prices of $90 and $95. I was hoping to protect my gains while also allowing for a holding period long enough to qualify me for long-term capital-gains tax treatment. Sadly, TSCO then inexplicably sold off to below $60 by April 2018. Ouch! Fortunately, the premiums I had received for my covered calls partly cushioned the blow. In fact, after getting over my anger about TSCO's pullback, I really went to town and bought even more shares of the stock. After all, TSCO was at an even-lower price-to-earnings ratio than when I first got into it, as this chart shows: So far, I've enjoyed sweet vindication for my strategy. TSCO closed Thursday at $99.59, meaning that my holdings are back in the black. My original shares are also now considered long-term holdings for tax purposes, and my second batch is almost there as well. My 12-month price target for the stock now sits at $108.10, or about 9.2% above the current quote. That's a fine situation for even more covered-call writing on my part. I can get hefty premiums on Jan. 17, 2020 $100 and $105 calls -- $9.20 for the $100 calls and $700 for the $105 ones. Even if the stock rises enough by Jan. 17 for someone to call away my shares, I'll get either $109.20 per share -- the $100 strike price plus a $9.20 premium -- or $112 a share (a $105 strike price plus a $7 premium): Getting called at those prices would represent full and fair value for my stock -- or perhaps even slightly above what I think TSCO should be worth by then. So, it's unlikely that I'll give up much potential upside. If TSCO rises above those strike prices but the option owners fail to exercise his or her call before Dec. 31, I'll also defer any realized gains into tax-year 2020. That means owing taxes in April 2021 rather than April 2020 had I sold the stock outright. Paying taxes later instead of sooner is always a good thing. Conversely, if TSCO remains unchanged or even pulls back, it'll be nice to have $7 or $9.20 per share in premiums to compensate for holding my stock through next Jan. 17. Those premiums represent downside protection of 7.07% and 9.29%, respectively, on my $105 and $100 calls. Getting that call-option money upfront provides a nice benefit, too. For each each 10 calls that I've written, I'll have collected either $7,000 or $9,200 that I can use to buy other stocks that look promising. This is a side-benefit of covered-call writing that the method's critics rarely mention. Using premiums collected in this fashion can really boost your portfolio's results if your secondary-stock purchases perform well. Covered Calls and IRAs and 401(k)s Writing covered calls in a 401(k) or IRA (where permitted) can also provide a way to make fresh cash contributions to your accounts using the premiums that you receive from options buyers. This money doesn't count against the normal annual limits that you face on making new contributions to these accounts yourself. I made $330,246 in cold, hard cash from covered-call sales within my traditional IRA account from 2011 through 2018. That very substantial amount -- almost one-third of $1 million -- then compounded over time as I put the money to work by buying additional investments for my account. Covered Call Risks vs. Rewards How do I answer the idea that selling covered calls limits upside while retaining all the risk of equity ownership? Well, consider these three points: Every stock you hold has the theoretical ability to go to zero. If something goes wrong with a stock you've sold calls on, simply buy the calls back at a profit and sell your shares. Every stock you've ever sold outright removed any chance for future gains. Why worry about something like that? Once you've collected your covered-call premium, the amount you receive has reduced your worst-case risk. That leaves you with less potential downside than regular stockholders of the same shares face. They haven't written any calls against their positions, so they haven't received any premiums from call buyers. Sure, if the underlying shares go wild to the upside, you'll be sorry to have capped your potential gains. But there are few if any investors who've never had that happen to them after selling their stocks outright. So, consider these undeniable benefits of covered-call writing: You have immediate guaranteed income.' Your downside protection is equal to the premium received. You have the chance to buy stock with other peoples' money. There's incentive to hold winning positions to attain long-term capital-gains-tax rates. Still, there are some important rules to follow when writing covered calls. For instance, you should only sell calls at strike prices that reward you with a reasonable net-selling price. Also, don't buy high-risk/high-reward stocks just so you can write covered calls on them in exchange for juicy premiums. High-risk stocks should simply be avoided or sold.

Make the Right Call With Covered Calls

This options strategy can save on your tax bill, offers downside protection and a bonus of immediate income.

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