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Thursday, February 17, 2011

Tax implications of covered call writing

To assess the tax implications of covered call writing one may choose to first understand what a covered call is and second become familiar with the tax implications associated with the covered call. Since covered call writing can involve both a loss or a gain, the tax implications will naturally vary dependent on the outcome of the covered call. This article will first illustrate the meaning of covered calls and then determine possible tax implications of such a financial transaction.

Defining covered call writing


Covered calls are a stock options trading method involving a combination of a 'long' position combined with a 'call option contract written by the security holder'. In other words the covered call involves two aspects 1) owning the security outright and 2) 'writing' the option to sell the underlying security at a strike price. In this case, the call is covered by the long position held by the security owner which means the call writer has hedged his or her call option with the ownership of the underlying security.

To illustrate further and in more simple terms, investor Y purchases 1000 shares of Greenmail Corporation at a price of $75.00/share, the investor then 'writes' an option to sell Greenmail Corporation at $80.00/share. If the contract costs the buyer $10.00/100 shares the total premium would be $100.00 if a contract for 1000 shares is purchased and the strike price is not exceeded by expiration of the call option. In the scenario the strike price is not met, the seller of the call option will keep the premium plus any difference between the strike price and the purchase pric. Covered call writing is further illustrated below:


Tax implications


Since the covered call stock option may lead to a loss or gain of money for the seller of the call option, the tax implications can vary. That is to say, if the underlying stock price declines and is sold and the option expires without reaching the strike price, the difference between the profit gained from writing the call option and the loss incurred through sale of stock will determine any loss.

Since the above scenario could qualify as wash sale because of two separate purchases of the same security within a 60 day period where a loss is realized on the underlying stock price, the loss on the sale of underlying stock may not be tax deductible. However, using a cost basis adjustment on the sale and/or purchase of a subsequent option may also minimize the loss from the wash sale. A few potential scenarios and their possible tax implications are listed below however do not replace the advice of a professional tax consultant:

• Underlying stock price decline + sale of call option: Cost adjusted wash sale may lead to tax deductibility on capital loss if an additional purchase of identical or similar stock takes place thereafter.

• Stock price rises + sale of call option: Taxation on capital gain if such gain is not within a tax protected financial instrument such as an individual retirement account.

• Stock price flat (with no sale) + expiration of call option: Taxation of premium will be incurred if the options trading is not within a tax protected investment vehicle.

• Stock price declines with sale + expiration of call option:. In such a case the capital loss may be tax deductible if sold within the same tax year and the retained premium on the call option may be taxed as ordinary income. A cost basis adjustment may not necessarily be applied to the options contract.

Tips for covered call writing and taxation questions


• Awareness: Since the covered call is a combination of two transactions the possibilities of scenarios increases. Being aware of all the possible scenarios and understanding them completely can be helpful in making the most of the covered call strategy

• Research: The covered call is a hedge against a decline in stock price. However, since the stock price could decline dramatically, the benefit of the hedge realized declines with the proportion in the decline of stock price. Such being the case, due diligence into the security, the market and other factors such as technical analysis can also be helpful in minimizing potential loss.

• Tax advice: Contacting and retaining a tax consultant may be advisable in a number of cases especially if one is engaging in a variety of options strategies.

• Tax code and authorities: For additional questions regarding taxation of investment strategies the capital investments division of the government tax authority may also be of assistance.

• Wash sales: Becoming familiar with the tax implications of wash sales when using options is advisable. To gain a more complete understanding of these implications consulting additional resources is advisable.

• Investment strategy: Having a well contemplated and investigated investment strategy may assist in the effective implementation of a covered call and application of corresponding tax scenarios.

• Brokerage services: While the use of a brokerage service may not include tax advice, the brokerage may be of assistance in understanding various uses of options thereby contributing to a better-informed investment strategy.

Tax implications of covered call writing vary on the outcome of the covered call investment strategy. Since a range of possible scenarios emerge when engaging in such a strategy a thorough knowledge of the tax benefits and hazards can be considered advisable either through independent research or through consultation with a tax professional.

While the information in this article does not replace the advice of a tax accountant or tax authorities it is recommended as a supplementary source of information to an overall covered call options strategy. It may also be helpful to the options investor to consult and cross-reference multiple sources of information to verify and become aware of the complete range of possible investment and tax scenarios.

Sources:

1. http://fairmark.com/forum/read.php?3,28029
2. http://www.investopedia.com/terms/c/coveredcall.asp
3. http://www.optionseducation.org/strategy/covered_call.jsp
4. http://www.irs.gov/pub/irs-pdf/p550.pdf
5. http://www.fairmark.com/capgain/wash/wsoption.htm