Systematic Covered Writing

 . . . more than just covered calls . . .

Question: I have been reading and following your various Call Writing emails with great interest and I think this can be a great income-stream generator.

The questions I have for you are:

1) Do you always wait till options almost till expiry to roll out OR roll them with the guide of Technical Indicator(s)?

2) Will this call writing exercise be more effectively deployed if initial position set-up were to buy LEAP Call option instead of Stock?

3) I read your last email on revisiting the Call Writing strategy, and have read your DTS strategy where you show us how to create 'paper loss' when value of stock has decreased significantly from the original position. Can you also show us an example of the Reverse DTS where the stock price is significantly higher than the Initial position?

Thank you.

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My Response:

1) There are two 'indicators' one uses to make the rolling decisions, with the more significant one being the extrinsic value remaining in the option.  As long as there is extrinsic value, the odds of early assignment are minimal.  Note that some data services refer to the extrinsic value as 'Time Value'.

The exception to this thought process would be if the stock is getting ready to pay a dividend that would make up the difference. This is more a matter of a math exercise than it is a 'Technical Indicator' in the purest sense. Here is an example as of July 13, 2007.

SNDK is trading at $54.76 and this position has a $45 strike price. The odds of this option being exercised early are slim.  Please note that does not mean it could not happen, just that it is very unlikely.  Here are the current values for this option:

Month	Strike Price	Symbol	Last	Chg	%Chg	Time Value	Bid	Ask	Vol	Open Interest
08 Jan	45	.SWFAI	13	0.4	3.17%	3.14	12.7	12.9	160	22,928

The difference between the current trading price and the strike price is $9.76.  This is, by definition, the intrinsic value of the option.

Stock Price - Strike Price = Intrinsic Value

Note that in order for there to be intrinsic value, the price of the stock must be above the strike price! Okay . . . so the value of the '08 Jan $45 call on SNDK as of July 13, 2007 should be at least $9.76.  That is what intrinsic value means. But . . . the option has an asking price of $12.90. The asking price minus the intrinsic value is the extrinsic, or time value of an option.

Ask Price - Intrinsic Value = Extrinsic Value

In this case, the extrinsic value is $12.90 minus $9.76 or $3.14. Hopefully, you realize that if someone were to exercise there 'right to buy' early, the writer would simply repurchase the stock at $54.76 and immediately sell exactly the same option for $12.90.  In the process, the writer would come out $314.00 ahead minus the fees involved.  That is why the option will not (but it can happen) be exercised early!

I mentioned there were two indicators . . . the other one is the open interest.  As the open interest, which is the number of open positions, approaches zero, the odds of early assignment increase so long as the extrinsic value is also approaching zero. The writer needs to be aware that he or she is playing a game of chicken . . . the seller of the option always has the right to buy the call back in order to prevent assignment. Of course this requires action on the writer's part.

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2) This question has been address previously.  Please see question 9 on the SysCW  FAQ's page for a detailed response. As luck would have it, the example uses the same stock as was randomly selected for the answer to your first question. I think the key difference, for I do know that a covered LEAP 'can' work, lies in the times when a stock loses value.  One would be hard pressed to 'make' up the cost of the LEAP if a stock was out of favor for a significant period of time.

The LEAP trader will point out that they can roll the LEAP rather than letting it expire, and they are right . . . but they are then also increasing the investment which needs to be recovered.  Yes, one can leverage their funds using covered LEAPS, but it is the writer's contention that their is an increased risk in that one now 'owns' a waiting asset.

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3) Actually. it is TDS not DTS.  TDS stands for Tax Deferment Strategy.  Yes, you can do it both ways.  The only issue is if one is going to report the stock position sold as the second purchase, rather than the first, this must be established at the time of sale.  Some firms, like e*Trade, allow the writer to specify lots at the time of sale, while other require a form to be completed.  The key is to be aware that the default is FIFO (first in first out). Now for that example you requested:

Reverse TDS   Example 1                                 OSTK  Overstock dot Com      

As can be expected, there needs to be an existing position.  In this case the Initial Position was established in February of 2004 as the following table indicates.

Date			Position	Investment	Generate	Total
27-Feb-04	Initial Stock Purchase		Buy 100 OSTK @ 27.80	($2,805.00)
			Overstock Com
27-Feb-04	Initial Call Option		Sell Jun $25 call @ 5.60		$535.00
						$535.00

By April, the value of the stock had increased to $36.00, and the 'news' seems to indicate that this stock was headed higher.  With the stock trading at more than $10 above the $25 strike price, the June option would be exercised sooner or later.  Liking the OSTK 'story', the covered writer wanted to reduce the effect of the stock being called.  Roughly, the position would be 'giving back' $280 of the $535 that was generated when the option was sold.  This can be 'seen' because the option strike price is $2.80 below the stock purchase price. With this in mind, one can see that the position will end with a realized capital gain of about $255.

Understanding the benefit of reducing realized capital gains by creating 'paper' realized losses coupled with the desire to maintain a holding in Overstock.Com inspired the following Reverse TDS position to be established.

Date	Strategy		Position	Investment	Generate	Total
19-Apr-04	Initial Stock Purchase		Buy 100 OSTK @ 36	($3,625.00)
			Overstock Com
19-Apr-04	Initial Call Option		Sell Dec $35 call @ 8.10		$785.00
	Reverse TDS Position					$785.00

It is important to keep in mind the IRS wash sale rule, which states that multiple positions must be maintained in the portfolio for a minimum of 30 days. This way the covered writer can 'choose' either the $3,625.00 or the $2,805.00 cost basis when (if) the Jun $25 option is exercised or closed early.

IMPORTANT: (You will read this more than once!)  In order to make use of the Systematic Covered Writing Reverse TDS strategy, the investor must be able to specify the lot of stock being sold with the brokerage firm. For example, at E*trade, this is accomplished by choosing the 'lot identification' method instead of FIFO or LIFO when setting up the account.  At Ameritrade, the investor sends a written memo to the firm.  The point?  If you cannot specify lots, you cannot use this strategy.  It's that simple.

As it turned out the February position was closed in early June to 'free' up funds for a new position.  At that time, the stock was trading slightly below the April $36.00 price.  The transaction data for the closed position is presented below.

Date	Strategy		Position	Investment	Generate	Total
27-Feb-04	Initial Stock Purchase		Buy 100 OSTK @ 27.80	($2,805.00)
			Overstock Com
27-Feb-04	Initial Call Option		Sell Jun $25 call @ 5.60		$535.00
4-Jun-04	Buy Call to Close Option		Buy Jun $25 call @ 10.90		($1,115.00)
4-Jun-04	Sell Stock to Close Position		Sell 100 OSTK @ 35.49	$3,524.00	$719.00
			Net Cash Gain			$139.00

The position is closed with a net (back to cash) profit of $139.00.  This may not seem like much, but factor in the conservative nature of the initial position.  Also, an investment of $2805 generated a profit of $139.00 in four months.  The return percentage is  the net profit divided by the net investment or  139 / 2805 = 4.955%.   If similar positions could be executed over the course of a year, the annualized return would be equal to three times the return for four months or 14.86%.  Now let's look at how the Reverse TDS position factors into the equation.  Here is how the February position will be reported to the IRS on Form Schedule D for 2004 tax year.

Date	Event	Cost	Proceeds	Gain
4/19/04	100 Shares OSTK Purchased	($3,625.00)
2/27/04	Jun $25 call Option Sold		$535.00
6/04/04	Jun $25 call Option Purchased	($1,115.00)
6/04/04	100 Shares of OSTK Sold		$3,524.00
	TOTALS	($4,740.00)	$4,059.00	($681.00)

Remember the brokerage firm will report the sale of 100 shares of OSTK on June 4, 2004 for $3,524.00 on IRS Form 1099. At the time of sale, the covered writer identified the stock being sold as the $3625.00 basis. There are two purchases of 100 shares of OSTK in the portfolio, and both purchases have been held for more than 30 days, the covered writer can choose the cost basis for the shares that were sold.  Did the covered writer make money or loose money?  The correct answer is 'both'.  A realized capital gain of $139.00 was generated, and at the same time a realized (but paper) loss was created though the use of the Reverse TDS concept developed for Systematic Covered Writing.

Can it get any better than that?  Well . . . yes!  As a bonus example let's continue with the OSTK position that was still active in the portfolio when the position above was closed.  To make it easy . . here is the data again.

Date	Strategy		Position	Investment	Generate	Total
19-Apr-04	Initial Stock Purchase		Buy 100 OSTK @ 36	($3,625.00)
			Overstock Com
19-Apr-04	Initial Call Option		Sell Dec $35 call @ 8.10		$785.00
	Reverse TDS Position					$785.00

Great news caused the value of OSTK to climb significantly between June and November of 2004.  How about it was trading at over $60 per share!  Keep in mind that the covered writer is always aware of the 'potential realized capital gain position'.  Because of closed positions that resulted in gains, the need to 'create' losses was still apparent in November.  The thought process was this ... OSTK is trading at over $60 in November, the December option will be exercised resulting in additional gains for 2004.  Can that gain be deferred to 2005 and create a realized 'paper' loss at the same time?  That is the question and here is the answer.  Sure.

Date	Strategy		Position	Investment	Generate	Total
19-Apr-04	Initial Stock Purchase		Buy 100 OSTK @ 36	($3,625.00)	TDS Used
			Overstock Com
19-Apr-04	Initial Call Option		Sell Dec $35 call @ 8.10		$785.00
17-Nov-04	Buy Back & Roll Out		Buy Dec $35 call @ 23.50		($2,375.00)
17-Nov-04	Continued Trade		Sell Mar $35 call @ 24.20		$2,395.00
						$805.00

The Dec $35 option was closed by purchasing it for $2,375.00. As can be seen, it was originally sold for $785.00.  The December option is now closed, which means it is reportable to the IRS as a capital event for 2004.  That event is a realized capital loss of $1,590.00.  Notice that the other transaction, which took place on November 17, 2004 was the sale of a Mar $35 call.  The amount of net cash generated by that sale was $20 more than the net cash used to close the Dec $35 call.  Realize that it was the $1590.00 loss that was created for the 2004 tax year that inspired the position to be rolled to 2005.

The preceding example is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The example does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendations in this example, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Before initiating the use of strategies involving tax issues, the reader is advised to consult with their CPA.  Systematic Covered Writing does not profess to provide tax advice.  The use of tax deferment strategies like the one illustrated above, when ever possible is suggested to possibly reduce your tax liability.  Whether a given strategy is appropriate for use in your portfolio is between you and your professional tax advisor.

On the other hand ... it is your money!

Your comments and opinions are worth sharing . . . . rlcoveru@wavecable.com

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN OSTK 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! STRATEGIES INVOLVING TAX ISSUES SHOULD BE DISCUSSED WITH YOU TAX PROFESSIONAL.

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 suggested 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 provided for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2007. All rights reserved.
Revised: 07/16/07