May 23, 2006 . . .        Tax Strategies in Use

Question: What do you do when a stock loses value?

Answer: Unless the underlying story of the stock changes significantly, the one thing the covered writer does is 'not panic'. The rational behind this statement is the belief that stocks go up as well as down, and the knowledge that there is a plan if the stock stays depressed. Here is that 'plan' for a taxable account:

•   Step One -- is to take advantage of the loss in value by creating 'realized capital loss' (on paper).

•   Step Two -- is to use the Dollar Cost Average strategy to lower the cost basis if necessary.

If a covered writer follows the IRS rules for reporting gains (which is highly recommended) on covered call options, he or she may have a dilemma.  That is, when the Initial Call Option expires, the proceeds from the option sale become a realized capital gain, as far as the IRS is concerned.  The cost basis for the option is $0.00 and the entire premium becomes a gain. There is nothing worse than having to pay tax on a position, even though the underlying stock has lost value.  Step One above is how the covered writer creates some 'good' out of a negative situation. The strategy is known as the TDS position (Tax Deferment Strategy position) of Systematic Covered Writing.

Commentary:

This is going to seem repetitive, but the covered writer has numerous positions using AGIX as the underlying stock. It is important to realize when email messages are sent out, the transactions actually take place, but they are not all in the same portfolio.  One benefit of this is derived from the fact that you can see the covered writer repeating the same process over and over.  This ability is fundamental to Systematic Covered Writing . . . it is after all,  a process.

AGIX has been a phenomenal Initial Position stock for over seven months now.  In December of 2006, it was providing almost a 50% premium and a very good return if exercised.  Because the premiums were, shall we say . . . ridiculous, 'extra' positions were held in various portfolios. Today's example simply illustrates what the covered writer does when a position loses value.

The Set Up - One way to create a loss without really losing is to open a position against an existing position. This strategy is known as the SysCW TDS (Tax Deferral Strategy) position. We will begin with an existing position as recorded in the Position Tracker as of February 14, 2006

Make note that when the Initial Position was established, the covered writer generated 49.07% of the net investment with the sale of the LEAP option. For those that would like to see how the Initial Position Math Exercise looked for this position when it was established in December click A Look Back.

That's the good news . .  .lots of down side protection.  Now take a look at the value of these 500 shares as of February 14, 2006. Do you see that there is about a $3000 difference between the investment and the current value?  This is exactly what the covered writer looks for, as it presents an opportunity to create a significant loss.

The 'process' is always the same. 

1. Establish a second position.

2. Write a call, generally short term, against this new position.

3. Close the position at a profit after waiting a minimum of thirty days.

4. Switch the cost basis so as to take advantage of the change in value.

Okay, it this case, the covered writer varied the second point slightly.  The option premiums for this stock are abnormally high, but only for the January 2007 expiration.  The covered writer has no idea why this is so, but simply accepts the fact that it is!  With this idea in mind, the writer sets up the TDS position by purchasing an additional 500 shares and selling a deep in the money option.  The writer want the downside protection and also realizes that at some point the extrinsic value of the January calls must diminish. This is one of those 'writing in the wall' scenarios.  The options simply cannot continue to carry the extra premiums as January approaches.

Here is the Position Tracker data for the TDS position that was established in February.

I kid you not . . . over 60% of the cash needed to buy this stock came from the sale of the call option!  For sure, a great deal of this premium would be 'given' back if the call were to be exercised.  This is because the strike price is $10 against a stock that was purchased for $15.30.  BUT . . . take the $5.30 per share away from the $9.40 premium . . . that still leaves a profit of $4.10 against a $15.30 investment.  This is a great Initial Position, just by itself, but don't forget the purpose . . . the covered writer is going to establish a loss.  This is the goal and as you will see, the position was 'set up' to do just that.

The Close - Okay . . . here it is, May 23 and the market is in kind of a 'funk'.  The covered writer is looking for some cash to establish new positions.  AGIX is now trading in the $13 range and the writer 'does the math' on closing the TDS position.  This math is pretty simple . . . what will it cost to buy back the five '07 Jan $10 LEAPS and how much will the sale of 500 shares of stock bring in.  Four amounts, two buys and two sells, and the covered writer can predetermine the back to cash outcome. 

Needless to say, it worked out fine, otherwise you would not be reading this!  Here is the closed position information as recorded in the Position Tracker today (May 23, 2006)

The math is the math . . . I can't just make this up! The TDS position is closed and back to cash.  The position generated $831.37 in back to cash profit in 98 days.  When annualized, that works out to over 40% . . EVEN THOUGH . . . the stock that was purchased for $15.30 was sold for $13.62.  In this case . . . the profit was generated by the decrease in the value of the call option.

Remember . . . TDS position must end with a profit.  This one did just fine!  Now, how about the loss?  Again, this might seem complicated, but it's not! The writer has a closed option position.  The '07 Jan $10 LEAP is closed.  The cost basis is known, as are the proceeds from the sale of the option contracts.  The writer also knows the proceeds from the sale of 500 shares of AGIX ($3,809.00).  The 'loss' will be created by selecting the older shares as the cost basis for this sale. Just like the covered writer planned back in February.

Here is how this data will be recorded in the SysCW Gains Tracker.  Keep in mind, as far as the IRS is concerned the older shares are always sold first, which is exactly how the writer wants the shares allocated.

Note that the light green highlighted rows are closed positions.  They are closed because there is both a cost basis and a proceeds amount. Now look at the total in the 2006 Gain column.  Bummer!  A loss of $2,178.23 was created at the same time a real back to cash profit of $831.37 was generated.

So, is the covered writer 'bummed' because the market is down?  It's a process . . . it was planned, and it happened just like it was supposed to.  Make money and lose money at the same time.

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN AGIX STOCK, OR ANY OTHER EQUITY.  THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED!

The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.

These are the terms of use.  Why are they here?  Because the examples provided are real.  The transactions actually took place.  The dates are real, the positions are real.  Some transactions will have been executed on the day you receive the email.  What you are agreeing to, is the fact that in no way is it being suggesting that you can, or should, enter a similar position.  Why?  Because that would be providing investment advice and the Covered Writer is not authorized to do that.  There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice.  Therefore, you are agreeing that the preceding example was provide for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised: 02/05/07