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Covered call writing can be crafted to meet a multitude of trading styles, goals and personal risk tolerances. In this article, I will highlight yet another situation where we may utilize this great strategy. In this common hypothetical, we are preparing to sell a stock that has substantially appreciated in value and represents a source of long-term capital gains (LTCG) since we’ve owned the shares for more than a year and a day. I will use Nvidia Corporation (NASDAQ: NVDA) as a real-life example to discuss this strategy.

Setting up the trade

500 shares of NVDA were purchased in June of 2016 for $49.00 per share in a taxable account. On June 12, 2017 the stock had appreciated to $149.67. It was determined that shares should be sold for long-term capital gains of $100.49 per share. Since we are already in a favorable tax category, let’s evaluate if selling call options will enhance gains even more.

Possible strike price expiration results

  • If the short call strike ends out-of-the-money on expiration Friday, the option trade represents short-term capital gains and we still own the shares in a LTCG category. Shares can be sold or leveraged to write 5 more calls for the following contract month
  • If the short call expires in-the-money and no action is taken to buy back the 5 contracts, shares will be sold at the strike and the option premium will be incorporated into the stock sale as part of the long-term capital gain. If we decide to buy back the option at a loss (could be a gain as well) to avoid exercise, that potential loss can be used to offset part of the capital gain from share appreciation.

Option chain for NVDA on 6/12/2017

tax considerations for covered call writing

NVDA: Option Chain Evaluation when Capturing Long-Term Capital Gains

We see that $750.00 per contract can be generated by selling the near-the-money $150.00 strike. This amount potentially can be even higher by leveraging the Show or Fill Rule.

The Ellman Calculator results

calculating covered call returns

NVDA Calculations and Long-Term Capital Gains

The Ellman Calculator shows a potential 5.2% (5% + 0.2%) additional 1-month income stream by incorporating covered call writing into our long-term capital gain trade.

Discussion

Covered call writing can be tailored to enhance returns on a stock that has dramatically increased in value over a time frame of more than 1-year. This article portrayed a scenario where we are prepared to sell the stock in the near-term from a taxable account. The risk is in the stock price declining by more than the premium generated from the sale of the short call.

*Since I am not a tax expert, please check with your tax advisor before making any tax-related decisions.

**Thanks to Matt for inspiring this article.

Next live event

AAII National Conference

November 3rd – 5th: Loews Royal Pacific Resort Orlando Florida:

Exhibit Hall # 303

Workshop presentation Saturday 10:30 – 11:45 AM

Market tone

Global stocks reached new highs this week as US interest rates pulled back from recent highs. Oil moved higher to $51.50 per barrel from $49.50 last Friday. Equity volatility remains steady, little changed from last week’s reading of 9.50. This week’s economic and international news of importance:

  • US retail sales rebounded in September, rising 1.6%. Higher gasoline prices in the wake of Hurricane Harvey and a jump in auto sales were major contributors
  • Higher gas prices also contributed to a 0.5% advance in the Consumer Price Index in September
  • The International Monetary Fund (IMF) and World Bank, IMF economists released their latest World Economic Outlook. The fund’s growth forecast was slightly more upbeat, with global gross domestic product expected to expand 3.6% this year and 3.7% in 2018, a 0.1% increase from the last update in July
  • European Commission president Jean-Claude Juncker said on Friday that the United Kingdom would need to pay its “divorce bill” before discussions can proceed on trade and future relations between the UK and the European Union
  • Minutes from the September meeting of the US Federal Reserve’s Federal Open Market Committee show that “many” members thought another rate hike was likely to be warranted late this
  • With efforts to repeal and replace the Affordable Care Act stymied in Congress, President Trump this week issued an executive order to reform the health care sector. The order allows employers to band together to form groups, potentially lowering the cost of coverage. It also allows insurers to offer coverage across state lines
  • The European Central Bank appears to be shifting its exceptionally easy stance toward monetary policy before the end of the year. One proposal is to cut in half the rate at which it buys European bonds

THE WEEK AHEAD

Sun Oct 15th

  • Yellen speech at G30 International Banking Seminar

Mon Oct 16th

  • China: Consumer Price Index
  • Japan: Industrial production

Tue Oct 17th

  • UK: Industrial production

Wed Oct 18th

  • UK: Consumer Price Index
  • Eurozone: Consumer Price Index
  • US: Industrial Production

Thu Oct 19th

  • China: GDP, retail sales, industrial production
  • UK: Retail sales

Fri Oct 20th

For the week, the S&P 500 rose by 0.15% for a year-to-date return of 14.04%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I am currently moving to a neutral market assessment with an equal number of in-the-money and out-of-the-money strikes.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (9.61) moved down by 31%.

Much success to all,

Alan and the BCI team

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