Reducing Your Exposure with Covered Calls

Key Points

  • When you're highly concentrated in a single equity position, covered calls can be an effective way to slowly reduce your exposure and generate income. 
  • Find out how to select the quantities, prices and dates for liquidating your position over an extended period.
  • This process can potentially help you get favorable pricing and spread out your capital gains tax liability.  

You have a concentrated equity position in your portfolio. Maybe it's because you've worked for the same publicly traded corporation for many years and now own many shares of that company. Or perhaps you've been a successful investor for many years and have managed to amass a sizable position in one stock.

If either of these situations sounds familiar, you might be interested in how covered calls can help you reduce your exposure to an overly concentrated equity position.

When should I consider a covered call?

A covered call writer, or seller, is typically neutral to slightly bullish. When establishing a covered call position, most investors sell options with a strike price that is at the money (ATM) or slightly out of the money (OOTM).

  • If you select OOTM covered calls and the stock remains flat or declines in value, the options will eventually expire worthless. You'll get to keep the stock and the option premium you received when they were sold, with no further obligation.
  • If you select ATM covered calls and the stock declines in value, the options should expire worthless and the outcome is essentially the same.

When using covered calls for reducing your exposure in an overly concentrated position, you'll want to focus primarily on OOTM strike prices.

Profit and Loss Profile for a Covered Call

Profit and Loss Profile for a Covered Call

Source: Schwab Center for Financial Research 

Reducing your exposure

Let's walk through an example to see how you can put this strategy to work:

  • You own 30,000 shares of XYZ and this position comprises more than 75% of your total portfolio.

  • It is October 2012 and XYZ is currently trading at $76.15.

  • Your cost basis varies from $20 to $50 per share because you have accumulated these shares over a 15-year time period.

The highest the stock has been in the past two years is around $90. While you feel reaching $90 again is unlikely over the next three months, you believe it may be possible for XYZ to hit $90 by the middle of next year, and perhaps even $100 at a later date.

XYZ's Long-Term Performance

XYZs Long Term Performance

Source: StreetSmart Edge®

While you believe the long-term prospects of XYZ are strong, the 30% pullback in 2008 made you realize the risks of holding an overly concentrated position. While those losses have finally been fully recovered, you also know it could happen again.

You would like to pare down this XYZ position to about 10,000 shares. If you sell any of your position, you'll have capital gains tax liability, so let's say that you prefer to spread the sales over a few years. You also only want to sell if you can get a favorable price.

One way to potentially meet these objectives is to use a laddered covered call strategy—which involves selling small lots of covered calls against portions of your XYZ position with several different strike prices and expiration dates.

Select your calls

XYZ is a large-cap stock and it has LEAPs® options so you could potentially sell calls that expire in 2012, 2013 and 2014.

Select your calls

Source: StreetSmart Edge

Using all but the closest of the available expiration dates, consider entering the following five covered call trades. (Note that all "maximum gain" calculations below are based on a cost basis price of $76.15. Additional capital gains based on your original purchase price up to $76.15, will need to be added to these amounts.)

Five covered calls trades to consider

 

Trade 1

Trade 2

Trade 3

Trade 4

Trade 5

Set up

Sell 20 XYZ 11/17/2012 80 Calls @ .50

Sell 40 XYZ 01/19/2013 82.50 Calls @ .75

Sell 40 XYZ 02/16/2013 85 Calls @ .60

Sell 40 XYZ 05/18/2013 90 Calls @ .60

Sell 60 XYZ 01/18/2014 100 Calls @ .90

Time until expiration

33 days

96 days

124 days

215 days

460 days

Shares covered

2,000

4,000

4,000

4,000

6,000

Net proceeds

$1,000 (0.50 x 20 x 100)

$3,000 (0.75 x 40 x 100)

$2,400 (0.60 x 40 x 100)

$2,400 (0.60 x 40 x 100)

$5,400 (0.90 x 60 x 100)

Breakeven

$75.65 (stock price – option premium) or ($76.15 – .50)

$75.40 (stock price – option premium) or ($76.15 – .75)

$75.55 (stock price – option premium) or ($76.15 – .60)

$75.55 (stock price – option premium) or ($76.15 – .60)

$75.25 (stock price – option premium) or ($76.15 – .90)

Maximum gain

$8,700 (3.85 points on the stock + 0.50 points on the option x 20 x 100)

$28,400 (6.35 points on the stock + 0.75 points on the option x 40 x 100)

$37,800 (8.85 points on the stock + 0.60 points on the option x 40 x 100)

$57,800 (13.85 points on the stock + 0.60 points on the option x 40 x 100)

$148,500 (23.85 points on the stock + 0.90 points on the option x 60 x 100)

Maximum gain occurs at or above at expiration

$80

$82.50

$85

$90

$100

Source: Schwab Center for Financial Research

If all of these trades were entered now, the immediate cash proceeds generated would be $14,200 ($1,000 + $3,000 + $2,400 + $2,400 + $5,400). If your long-term forecast on XYZ is correct and you are fortunate enough to be assigned on all of these options, the end result will be total capital gains of $267,000 ($7,700 + $25,400 + $35,400 + $55,400 + $143,100).

You will have met your goal of slowly reducing your total position down to 10,000 shares, while also spreading your tax liability over three calendar years. (Note: These calculations are all based on a starting price of $76.15; depending upon the original cost basis of the shares sold, your actual capital gains will likely be much higher.)

Each of these trades could result in no assignment, a partial assignment, or a full assignment so it's impossible to evaluate all the possible scenarios here. Additionally, any time your covered calls go in the money, you are at risk of early assignment, and the risk is higher for dividend-paying stocks. If an early assignment occurs in the calendar year prior to expiration, your tax liability could change dramatically.

To simplify this evaluation, let's take a look at each of these trades individually and explore the different possible outcomes, proceeds, breakeven prices, etc., as each option expiration date is reached.

Trade 1

On November 17, 2012, if XYZ is above $80, you will be assigned on 2,000 shares:

  • Net proceeds = $160,000 ($80 x 2,000)

  • XYZ price appreciation = 3.85 points ($80 – $76.15)

  • Capital gains since trade date = $7,700 ($2,000 x 3.85)

  • Total gains = $8,700 (3.85 points on the stock + 0.50 points on the option x 20 x 100)

If XYZ is below $80, your 20 short call options will expire worthless. However this strategy would still be profitable unless XYZ has dropped below the breakeven price of $75.65.

Trade 2

On January 19, 2013, if XYZ is above $82.50, you will be assigned on 4,000 shares:

  • Net proceeds = $330,000 ($82.50 x 4,000)

  • XYZ price appreciation = 6.35 points ($82.50 – $76.15)

  • Capital gains since trade date = $25,400 (4,000 x 6.35)

  • Total gains = $28,400 (6.35 points on the stock + 0.75 points on the option x 40 x 100)

If XYZ is below $82.50, your 40 short call options will expire worthless. However, this strategy would still be profitable unless XYZ has dropped below the breakeven price of $75.40.

Trade 3

On February 16, 2013, if XYZ is above $85, you will be assigned on 4,000 shares:

  • Net proceeds = $340,000 ($85 x 4,000)

  • XYZ price appreciation = 8.85 points ($85 – $76.15)

  • Capital gains since trade date = $35,400 (4,000 x 8.85)

  • Total gains = $37,800 (8.85 points on the stock + 0.60 points on the option x 40 x 100)

If XYZ is below $85, your 40 short call options will expire worthless. However, this strategy would still be profitable unless XYZ has dropped below the breakeven price of $75.55.

Trade 4

On May 18, 2013, if XYZ is above $90, you will be assigned on 4,000 shares:

  • Net proceeds = $360,000 ($90 x 4,000)

  • XYZ price appreciation = 13.85 points ($90 – $76.15)

  • Capital gains since trade date = $55,400 (4,000 x 13.85)

  • Total gains = $57,800 (13.85 points on the stock + 0.60 points on the option x 40 x 100)

If XYZ is below $90, your 40 short call options will expire worthless. However, this strategy would still be profitable unless XYZ has dropped below the breakeven price of $75.55.

Trade 5

On January 18, 2014, if XYZ is above $100, you will be assigned on 6,000 shares:

  • Net proceeds = $600,000 ($100 x 6,000)

  • XYZ price appreciation = 23.85 points ($100 – $76.15)

  • Capital gains since trade date = $143,100 (6,000 x 23.85)

  • Total gains = $148,500 (23.85 points on the stock + 0.90 points on the option x 60 x 100)

If XYZ is below $100, your 60 short call options will expire worthless. However, this strategy would still be profitable unless XYZ has dropped below the breakeven price of $75.25.

Below is the breakdown of proceeds of these trades over three years. (Again these "capital gains" calculations are based on the starting price of $76.15, not your original cost basis, which is likely much lower.)

2012:

Option premiums received: $14,200 ($1,000 + $3,000 + $2,400 + $2,400 + $5,400)
Capital gains: $7,700 (Trade 1 only)

2013:
Capital gains: $116,200 ($25,400 + $35,400 + $55,400) (Trade 2, Trade 3 and Trade 4 only)

2014:
Capital gains: $143,100 (Trade 5 only)

Of course, the price of XYZ could rise and fall many times over the 460 days from the day you enter these trades until the day the last option expires. This means some of these options may be assigned in full, in part, or not at all.

If evaluated in aggregate, the option premiums received and the profit earned (if any) on each of these trades would effectively lower the breakeven price of all subsequent trades. For example, if all of these options ended up expiring worthless, the breakeven price on all 20,000 shares of XYZ would be lowered by $0.71 ($14,200/ 20,000).

For any options that expire worthless, the shares originally associated with those options will be freed up again, allowing you to sell additional covered calls for future expirations, sell the shares in the market, or simply hang on to them. In each case, however, you will have earned a small option premium in the interim.

What to remember about covered calls:

  • Covered calls will usually constrain significant profit potential if a stock moves substantially in your favor.

  • Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit for you.

  • It's rarely a good idea to sell a covered call if your stock position has already moved significantly against you. This could cause you to establish a closing price that ensures a loss to you.

  • To ensure that you do not lock in a losing trade, before you sell a covered call, always ask yourself the question, "Would I be happy if I had to sell my stock position at the strike price on this option?" If you can answer yes to this question, you will probably be okay.

  • If your covered call is in the money, you could be assigned at any time.

  • Stocks that pay dividends are especially vulnerable to early assignment on in-the-money calls. This assignment will most likely occur on the business day right before the ex-dividend date.

The examples above discuss five specific strike prices, quantities and expiration dates. Based upon your outlook for XYZ, you may decide to sell a greater or a fewer number of contracts at each of the different expirations, and you may choose higher or lower strike prices. The potential variations are too numerous to discuss here but I hope this serves as a guide for your own strategy. 

 

Next Steps

Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
Not yet a client? Learn more about Schwab Trading Services.

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Important Disclosures