Paul F. writes: “I have been extremely successful using a strategy of selling covered calls with IOM (Iomega). I bought at 32, doing a buy-write [buy the stock and simultaneously sell a call against it] and dropping my basis down to $29.50 a share. I continued to write covered calls as the stock continued to drop. My goal had always been to make 20% profit on the stock. My last covered calls were written when the stock perked up to 17, and that dropped my basis down from $14 a share to $12 (all commissions figured in). Now that IOM is up to $18 a share range, I might get called out. But, who cares? My basis is $12 and I would get $17.5 a share. That’s more than the 20% I originally wanted. If I don’t get called, I will wait until it perks up to 18.5-20 and write the $20 calls, lowering my basis again, and increasing my guaranteed profit margin if I get called!”

Do you see what he’s doing? He buys a stock and at the same time sells someone a call on it at a higher price. So if it goes way up and it’s “called away,” he misses out on the bonanza, but still has a nice profit.

In this case, when he first bought the stock at 32, his effective cost was only $29.50, because he was paid 2.5 points ($250 on each 100 shares) to sell (or “write”) the calls.

He probably wrote the 35 calls, giving someone else the right to buy his stock any time in the next few months for 35.

If the stock shot up to 60, he would have gotten only 35 for it — missing the extra 25 points. But he would still have done nicely: selling for 35 stock he’d bought for an effective cost of 29.50. Not a bad profit for a few months — 18.6% before commissions and taxes.

Of course, in this example the fellow buying the call for $2.50 would have done a lot better, exercising his right to buy at $35 a stock he could have simultaneously sold for $60, and realizing a $25 profit less the $2.50 he paid for the calls, commissions and taxes. With 10 calls, say, representing 1,000 shares of stock, that would be about $22,000 profit on a $2,500 speculation in just a few months.

But how often do stocks run up from 32 to 60 in a few months, and what are the chances you will catch them just before they do?

Options trading is a “zero-sum game” — for each winner there is a loser — less commissions and taxes. In stocks, everyone can theoretically be a winner, as the economy purrs along, throwing off dividends and perhaps even growing. In options, on average, everyone loses: it’s a less-than-zero-sum game because of the commissions and taxes.

Of course, as Paul describes, Iomega did not shoot up from 32 to 60 right after he bought it. Instead, over time, it staggered down, down, down. And every so often, when one set of calls expired worthless (pity the poor guy who did pay $2,500 for the ten 35 calls, hoping the stock would shoot up), he’d write another set, for another premium, at a lower price.

In his mind, his “basis” on the stock he had originally purchased at 32 is now down to 12. (I guess he’s been doing this for quite a while now.) But that’s not how it works for tax purposes. As Paul probably knows, each premium he receives for selling a call is taxable as ordinary income. His tax basis of $32 a share on the stock itself remains unchanged. So unless he’s doing this in a tax-sheltered account, one thing about this strategy is that it assures that much or all of any profit you make will be fully taxed. Between federal and state income taxes, that can be a big handicap.

(Someone who can compound $10,000 in a stock at 20% a year, untaxed until he sells 20 years later, turns that $10,000 into $383,000. Figure he’s in the 40% tax bracket, and that’s $230,000 after tax. The same person earning the same astonishing 20% but paying tax on it each year will have $96,000.)

And there are the commissions along the way, for buying the stock and then selling each successive crop of calls.

Still, there’s no question this strategy can work out OK — it has for Paul.

But what if the Iomega he had bought at 32 dropped to 16 within just a few months. Then he would have paid $32,000 for 1,000 shares (say), received $2,500 to write those first calls . . . and now what? He’s lost (in this example) nearly $14,000. He can write more calls, but before doing so he should recognize that doing so is really a separate decision. He may think of it as part of one long strategy, but each move is a separate gamble. Say, in this hypothetical, he had written IOM 20 calls when the stock was 16, getting $1,500 for doing so — but then the stock dropped to 8. Ugh! (He’d have lost nearly $6,000 more.) Or the stock shot to 30. Ugh! (It would have been called away from him at 20 — how much better he’d have fared if he hadn’t written that second call.)

You can construct endless scenarios, and for conservative types who nonetheless enjoy “action” and “the game,” writing calls can be a relatively sensible way to play. Kind of like going to Las Vegas and betting red or black at roulette, with small stakes. You can stay at the table a LONG time without losing much. If you’re lucky, you may even win, even though the house (commissions and taxes) makes that less and less likely the longer you play.

You may even have a special knack or insight that allows you to do better than the averages would predict. You may be a fairly consistent winner in this zero-sum game if you can identify stocks that will not fall too sharply. You’ll be getting premiums, you’ll be getting dividends (although dividend-paying stocks tend to be far less volatile than the Iomegas of this world, and thus to provide far lower premiums when you write the calls), and you may also get price appreciation as the stock gradually inches up over the years — or even if it shoots up and gets called away from you.

In other words, most of the time, you’ll make money. Once in a while, you’ll get really hosed. Good luck, Paul. You may just have the knack.

Personally, I only write calls when I have a stock I don’t want to sell (because of taxes), but which I think has really gotten ahead of itself. I haven’t done it much, and with only mixed success.

 

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