My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Thursday, May 26, 2011

Covered Calls

Investors are always looking to reduce their risk in owning a specific stock. One method to reduce that risk is to use a covered call strategy.

Selling covered calls is a strategy in which an investor sells a call option contract while at the same time owning an equivalent number of shares in the underlying stock. It is considered to be one of the safest option strategies in the market.

In simple terms a covered call means you sell a call option to another investor which entitles them to purchase a stock you already own at a specified price. The concept is best illustrated by an example.

You purchase 100 shares of Research and Motion for $58/share and agree to sell it for $60 on the third Friday of the following month.  You receive $4/share for selling this call option. The return calculation is as follows:

Cost of 100 shares at $58/share                        $   5,800
Call premium received – 100 @ $4  ****                     400      - 7% return immediately

If the stock price is above $60 at strike
date, investor receives another $2 ($60-$58)               200      - 3% return

Total return on investment is                                    $600      - 10%

**** The $400 call premium is a capital gain in the year it is received and is not a reduction in the cost base. See my comment to Anonymous in the comment section below for the income tax treatment

If the stock price is below $60 at strike date, the stock will not be called and you will keep the $400 time premium.  However, you have lowered your out of pocket cost of your investment to $5,400 and you still own the stock. Please note that you must hold the stock until the call is exercised or expires.

The downside to using this strategy is that if the stock price rises above $60 you do not participate in any of the upside above $60. Therefore, using a covered call may be more risky for a stock like Research in Motion which can swing dramatically, than for a stock like the Royal Bank, but that would be reflected in the premium you get for selling the call.

In the case of a stock such as Bell Canada that pays dividends, one has to be aware that the  call holders may want to capture the dividend and that has to be factored in.

As often happens in blogging, someone else covers the topic of your blog before you post it. An excellent  detailed step by step summary of the mechanics of writing a covered call are covered in this blog by The Million Dollar Journey.

Please understand that I am in no way recommending a covered call strategy. I am only discussing the concept so you are aware of its existence. The use of a covered call is complex and you should consult with your investment advisor before undertaking such a strategy or if you trade yourself, ensure you grasp the complexities in doing such.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

12 comments:

  1. But how do you account for it on your income tax return? Does it lower your cost base for the stock, or is it accounted for as a separate transaction?

    What if it's Dec.2011, and you sell a July 2012 call for $8. You've cashed in $800. Then you buy back the call to close the position in Marc 2012 for $5. So, profit of $3. But in which year do you report the income?

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  2. Hi Mark, can you sell options on stocks held in an RRSP or TSFA?

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  3. I've sold covered calls in my RRSP. You can also buy calls and puts in your RRSP.

    But you cannot sell naked calls or puts in your RRSP.

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  4. Anon, great question. In my example i reflected the $4 as a reduction in the cost base to try and show the percentage return advantage of using a covered call, but this is misleading. I am going to change the example. When you sell the covered call option for $4, the $4 is a capital gain (if naked call option maybe income)in the year it is sold. If the call expires, nothing further is required, however, if the option is called in a future year, technically (practically not necessairly always done) the prior year return is to be amended and the $4 removed and the $60 received plus the $4 premium=$64 becomes your proceeds of disposition in that future year. If the option is called in the same year, you again have $64 of proceeds, but technically $4 in one transaction and $60 in another.

    In regard to your second question, I unfortunately do not have the time to get into it now.

    Here is a link to a great blog on the taxation of options and calls.

    http://blog.taxresource.ca/how-stock-options-are-taxed/

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  5. Simon, as far as I know, Annon is correct. I checked with a broker and they think it can also be done in a TFSA, but you will have to check with your brokerage house.

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  6. Great synopsis Mark. I trade myself and constantly use this strategy. I find tracking all my trading activities cumbersome and difficult (especially for tax purposes). Mark, are you aware of a program that can assist with this for tax purposes?

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  7. The Blunt Bean CounterMay 26, 2011 at 10:42 PM

    thx Anon- Unfortunately I am not aware of such a program. The reality is that this is so complex and time consuming, that many people hire a bookkeeper specifically for this or throw up their hands and just report using a method they feel is easiest for them, technically wrong but practically they dont care as they feel it evens out over time.

    p.s.- Blogger is not allowing me to comment as the Blunt Bean Counter (pic with suit), so I am just commenting through regular comments

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  8. "throw up their hands and just
    report using a method they feel
    is easiest for them, technically wrong"


    Could you provide more info on this? What happens if CRA doesn't like this? I'm not talking about a case of tax evasion here, I'm talking about a case where income was reported in a logical, consistent, but technically wrong way.

    eg:
    Sell to open naked put in 2009. buy to close transaction in 2010. Report entire transaction and net profit/loss in 2010.

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  9. Anon, not to clog board, send me an email at address on header at top of the page

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  10. Being very new at this, I wonder if you can clarify...

    I purchase 100 shares of XYZ for $10000. In March 2016 I write a call and receive $300. It expires in August 2016. So I write another call immediately, for $260, and it gets called away in February 2017 when I receive $12000 for the sale. How does this work? My best guess:

    I claim $300 cap gain in 2016 and that's the end of that; I don't have to think of this one again because it expired.
    I'm supposed to also claim $260 as cap gain for 2016, but then I will have to file an amendment to my 2016 taxes so that I can claim $2000 + $260 as a cap gain in 2017.

    I have been told that it's OK to simply claim the cap gain only at the time the call expires/is called. If that is the case, I wouldn't bother with the $260 on my 2016 return and just wait until the expiry date/sale. However, I can find nothing from CRA or any 'tax tips' source that explicitly says this is acceptable.

    Any suggestions? It does seem slightly ridiculous to claim the $260 for 2016, especially since I already know at the time of filing that I will have to 'undo' the claim. Am I missing something here?

    Thanks!​

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    Replies
    1. See this link. http://www.taxtips.ca/personaltax/investing/taxtreatment/options.htm

      I do not provide tax planning advice on this blog. I will say that many people file incorrectly in respect of puts and calls, some because they dont know what is right and some because they cant be bothered to do what is correct.

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    2. Thanks for the link. I see this is likely a case of the correct method and the common method differing, whether due to ignorance or expedience (who am I to judge?). Guess I'll be learning about T-1Adj forms! The excitement is killing me. ;-)

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