As 2012 rapidly comes to a close, a lot of investors and traders focus their attention on tax matters. Alan Ellman of TheBlueCollarInvestor.com details a tax-efficient option strategy for stocks that you may want to keep.

For covered call writers, the main stock option strategy is to purchase an equity specifically for the purpose of selling the corresponding call option. The investment time frame is one to two months as earnings reports will end the "run" of even the best performing equities (if you agree with my guidelines). In many cases, share assignment is permitted by the seller and even if early assignment occurs, our investment would still have been a successful one. In other words, losing (selling) the stock is no problem and really just part of the strategy.

There are other investors who sell call options in a different manner, called portfolio overwriting. In this instance, a call option is sold on a stock already part of an existing portfolio. That option is selected in a manner where it is NOT expected to be exercised. Remember that you need to own 100 shares for every options contract sold.

Why a Portfolio Overwriter Does Not Want His Shares Assigned
This is basically a tax issue. The holding period for short-term versus long-term capital gains is one year. If the stock has been held for less than that time frame, the writer would prefer to retain the equity for a longer time frame. In addition, if the shares have appreciated substantially from the cost basis, selling in any time frame may not be in the investor's best interest.

Another Important Tax Issue
If the underlying stock has not accumulated the full one-year holding period for long-term capital gains, covered call writing may suspend or eliminate the current accumulated holding period. It is advisable to consult with your tax advisor on this matter.

Advantages of Portfolio Overwriting

  • Achieve higher returns in declining, neutral, and slightly bullish markets
  • Beat the returns of long-term holders of equities
  • Increase portfolio downside protection, thereby minimizing risk
  • Generate a monthly cash flow
  • Use option profits to compound your money

Strike Selection for Portfolio Overwriting
Since our goals are to generate a monthly cash flow and NOT have our shares assigned, common sense dictates that we sell out-of-the-money strikes. This will benefit us in that time decay is greatest for these strikes and option value will dissipate as we get closer to expiration Friday. Remember, we don't want our option strike price ending up in-the-money (lower than current market value of the stock).

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