What to Do with a Covered Call when the Stock Goes Up


Before I ever write a covered call, I make sure that I would not mind parting with the stock at the strike price.  I usually only write them on stocks that have gone up a lot in my portfolio, that I still think have good longterm appreciation potential (meaning that the company is still doing well at their business and have room to grow), but that have gotten too pricey for their current value.

For example, I recently wrote some covered calls on BJ’s Restaurants International.  I had bought the shares at somewhere around $20, I thought the stock was expensive at $45, but then the price continued to climb to around $60.  With a PE approaching 50, it was clear that although this is a great, growing company, it will take a while for earnings to justify the high price.  Rather than wait around for earnings to grow, I decided to write some covered calls and gain an income from the stock.
As it happened, the stock did go higher, and as expiration date approached it was a couple of dollars above my strike price.  (Note, options can, but almost never are, be executed before the expiration date.  Typically, however, they are executed just before expiration, so you are usually safe to wait until at least the week of expiration before taking action.)  In this case I analyzed the stock price and decided that I would not buy the shares at that price, so why should I close the position and effectively raise my cost basis.  I decided in this case to go ahead and let the shares be sold.  I bought back part of the position a few weeks later for about $10 less per share.
If I had decided that I didn’t want to lose the shares – for example if doing so would trigger a tax bill I didn’t want to pay, or if I would probably just buy the shares back at the current price and the cost of commissions for buying back the shares exceeded the cost of trading options, I might close the option position by buying an offsetting call option.  While this might cause a loss (depending on the premiums you collected when you wrote the calls and how far above the strike price the stock is), you are generally trading cash for the stock at a higher price.  In other words, you are increasing your effective cost basis on the stock.
For example, supposed you sold Jun $50 calls on XYZ corp and the stock went to $52.  Near expiration, the price of the call would be somewhere around $2.10 – the difference between the current stock price and the strike price, plus a small premium for the remaining life of the option.  If you were to close the position by buying an offsetting Jun $50 call, you would be paying $210 per option plus broker fees.  If you sold the calls originally for $1.20, you have now increased the amount you have in the stock by $2.10 – $1.20 = $.90 per share.  Note that the stock is also higher in price, so you really didn’t lose the money (yet), but you are increasing how much you have in the stock.  You should therefore ask yourself if you would buy the stock at the current price.  If not, let the stock be called away.  If so, then cover the position.
Another thing that can be done to offset the loss is to “roll the option” to a higher strike price and a later expiration date.  In our example, let’s say that you see the August $53 call is selling for $1.50.  You could close your Jun $50 calls and write an August $53 call.  This would increase the price at which you would lose the shares, giving you another dollar of breathing room, and the $1.50 in premiums you would collect would offset the price you are paying to close out the position.  Note there is a slight risk here that your existing option could be executed before you close the position, particularly if you are very close to expiration.  In that case you could end up with a naked call rather than a covered call – a very precarious position.  It would be a good idea to verify with your broker that you have not been assigned an execution before writing the new calls.
Finally, there is another reason you might wish to close the position.  Because a written call looks like short interest in your account, a stock that has gone up far above the strike price may cause your account to go into margin.  You are then paying interest and are possibly subject to a margin call even though the increase in the stock price will offset the loss on the call directly.  If this is the case, and it is a while until expiration, the best strategy is to close the option position and sell the shares to make up the deficit rather than waiting for the option to be executed.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What will Happen to Stock Prices if Capital Gains Taxes Go Up?


With the call for capital gains tax increases making the rounds, investors would be very reasonable to wonder what effect an increase would have on their portfolios.  Obviously an increase would mean that you would receive less money when you sold a stock at a gain.  An increase in the gains rate, however, would immediately affect the stock market, causing a drop in prices.  Ironically, the effect of that drop may be to cause additional losses to be realized, resulting in the amount of capital gains and ordinary income taxes to actually go down.
To understand why stock prices would fall, you need to understand risk/return ratios and the market pricing system.  First we’ll discuss risk and reward.
All investments have risks and potential rewards.  The greater the risk, the greater the potential reward that is required for investors to place their money in it.
In a bank account, the rate of return is virtually guaranteed (to see why it is only “virtually” guaranteed, see the bank crash of the Great Depression, the S&L crisis of the 1980’s and the recent bank collapse in 2008).  If you put $100 in a bank CD at 1% interest, you would expect to have $105 in the account at the end of the first year.  There is almost no risk, and therefore the return can be fairly small.
With common stocks, a lot of the return comes from capital gains.  Capital gains, in turn, are due to price increases, which are caused (at least in the long-term) by earnings growth.  As earnings grow, even if the company does not pay a dividend, it has the potential to pay a bigger dividend in the future.  Therefore, investors are willing to pay more for the stock.
Earnings for a company, however, are in no way guaranteed.  Earnings depend on a lot of factors, most of which are difficult to predict, especially a few years out.  The price of a stock therefore is based on the current earnings and expectations of future earnings, discounted by some amount to account for risk.  (Discount in this case is a fancy financial term meaning that the price is lower than it is expected to be in the future, assuming a certain return).  The more uncertain the future earnings, the greater will be the discount.
This makes perfect sense if you think about it.  If you loaned someone $1000 whom you were sure would repay you, you would probably not require much interest if any.  If a person who you know stiffed you or a friend in the past asked you for a loan, you would not make it unless that person offered to pay you back substantially more for the risk.  Maybe you’d require $2000 back in a month, with payments each week, if you only believed the chance of being repaid was only 50-50.
With stocks, if one thinks that the chance of actually making the expected earnings in a year is 50-50, you might not be willing to invest unless you thought the stock would increase by 30% if the earnings target is met.  You would therefore not pay more for the stock than 30% lower than the expected value if the expected earnings are made.  This means that in exchange for taking the risk, you expect to get a 30% return.  If you buy four such stocks, you’ll make 30% on two of them and break even or lose money on the other two, assuming they follow the odds exactly.  This means you would receive a greater return than you would with a bank account.  If you were only going to receive a 1% return and the bank was paying 1%, you would just stick your money int he bank and not take the risk.
Note that the expected price if earnings are made can be predicted fairly reliably by looking at past Price- Earnings ratios (PE).  Because stocks typically trade in the same PE range, you can do a reasonable job of predicting the price range by multiplying the expected future earnings by the low and high values of the range.  You could also use Price-Sales ratios (PS) in cases where the stock has no earnings or negative earnings at times.
So how do you know that you are paying the right amount for a stock?  Luckily, you don’t need to calculate the earnings risk because the market does that for you.  By constantly trading, stock prices are continuously adjusted based on new events and changes in the fundamentals.  While prices may diverge for short amounts of time due to various trading schemes being employed, they will always eventually return to a reasonable price given the risk.
Now back to the effect of capital gains tax increases.   The effect of taxes is to lower the return one receives.  In order to once again provide the needed return for the given risk, share prices would need to decline by a like amount.  This means that the price of stocks will go down as soon as tax increases are expected.
How much will it go down?  Well, the profit will be reduced by the percentage increase in taxes, times the expected rate of return.  For stocks, a 15% return is a reasonable number (although the return will vary depending on how volatile the stock is).  Using 15% return, the following are predictions of the effect of changes in the capital gains rate:
New Rate                             Average %Change in Price              Expected change in 11,000 DJIA
20%                                                   -0.75%                                                                     -$82.5
35%                                                    -3%                                                                          -$330
90%                                                    -11.25%                                                                   -$1240
While the change is not that large compared to other effects, taxes collected could be reduced by a substantial amount.  Assume that the US market capitalization (the current value of the stock market) is about $50 Trillion, as it was in August of 2008.  The amount of wealth destroyed by the different market changes is shown below:
New Rate                             Average %Change in Price              Market Loss            Tax Reduction
20%                                                   -0.75%                                                           $37o B                      $75 B
35%                                                    -3%                                                                $1.5 T                         $300B
90%                                                    -11.25%                                                         $5.6 T                         $1.13 T
So, if taxes were raised to 90% for capital gains, as some are proposing, taxes collected would actually be $1.13T less than expected, just because of the drop in stock prices that would result.  This doesn’t take into account people not investing at all because the taxes were so high.  This would affect both capital gains and the availability of jobs.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Debt management still important when economy begins to recover


Today’s post is a guest post about debt management.   Certainly getting rid of debt is the first step in building wealth.   SI

Responding to comments from the International Monetary Fund (IMF) that an economic recovery could be slowed down by high levels of household debt in the UK, financial solutions company Think Money has said that the difficulties facing the economy still pose a threat to many people, and anyone experiencing problems with repaying their debt should seek debt advice as soon as possible.

After Chancellor Alistair Darling told The Times that the recession would be over by Christmas, the IMF said that Britain had “set the stage for sustainable recovery”. However, it added that high household debt – as well as the Government’s own debt – could be holding back a recovery.

In its annual health check of the UK’s economy, the IMF said: “The recovery is expected to be subdued and gradual as banks and households go through a difficult balance sheet restructuring process.”

Levels of personal debt have been on a rising trend throughout the recession, most likely due to a combination of rising unemployment, falling incomes and higher costs of living.

Indeed, Ministry of Justice insolvency figures showed a significant year-on-year rise in debtor’s petitions for bankruptcy (i.e. applications by the borrowers themselves) in the first quarter of 2009, with 29% more petitions put forward than in the same period in 2008, and 9% more than in the previous quarter.

A spokesperson for Think Money said that the levels of debt amongst British households highlighted the need for careful financial planning and effective debt management.

“The sharp increase in debtors’ bankruptcy petitions in the first quarter of this year gives a stark picture of the problems facing some people at the moment, but it is also only the tip of the iceberg,” she said.

“There are also likely to be large numbers of people who are not necessarily facing bankruptcy, but are nonetheless having real problems with meeting their debt repayments and other financial commitments – and anyone in that situation should address the problem as a matter of urgency.

“Because interest causes debt to grow, it’s very important that borrowers do their best to ensure they are making each of their debt repayments on time. If they repeatedly miss payments, the interest can cause the debts to ‘snowball’, and that can put the borrower in an even more difficult position.”

The spokesperson added that if borrowers are experiencing problems with their repayments, they should not hesitate to seek professional debt advice.

“There are a range of debt solutions available that can help borrowers to clear their debts. For example, if the borrower cannot keep up with their current debt repayments but feels they may be more able to repay their debts at a slower pace, a debt management plan could help.

“Even if the borrower feels they will never be able to repay their debts in full, a debt adviser could help them to find a debt solution that will help them to clear as much of the debt as possible.

“It may even be that the borrower simply needs help with organising their finances in order to help them repay their debts. Whatever the case, a debt adviser can recommend the best course of action based on the borrower’s circumstances and needs.”

Please send investment questions to vtsioriginal@yahoo.com or use the form .

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.