Systematic Covered Writing

 . . . more than just covered calls . . .

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Tax loss strategies are used in the Systematic Covered Writing process to defer taxes. This is no different than claiming all the deductions possible to reduce your earned income tax liability.  Having said that . . . please verify this process with your CPA .  It is important that your professional advisors are on the same page as your investment strategies.

As with all SysCW examples, the transactions listed in the information that follows took place on the dates listed.  Note that historical executions of various transactions may, or may not, be repeated in the future,

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DNDN Tax Deferral Strategy Example

THE DATE: February 21, 2007

THE STOCK:  Dendreon Corporation (DNDN) is a biotechnology company focused on the discovery, development and commercialization of therapeutics that harness the immune system to fight cancer.

THE STRATEGY: The strategies used with this new position are the Tax Deferral Strategy (TDS) position coupled with a possible Dollar Cost Averaging ($CA) position.  This combination position can be used with inexpensive stocks as the funds required to establish the new holding are kept to a minimum.

WHY TDS:  There will be times when a stock loses significant value.  In a taxable account a covered writer looks at this negative event as a positive opportunity. The opportunity at hand is to use the depressed stock to create a paper realized capital loss, which in turn can be used to reduce the current liability created with realized gains. The idea is to maintain control of the capital that would be used for taxes for at least another year, if not longer.  Just as a tax payer looks for all the legitimate deductions he or she can find, an investor should do the same.

WHY Dollar Cost Averaging: When stocks languish below their original cost basis, the opportunity to average the cost basis presents itself as a viable method for 'getting back to even' with the underlying stock. Keep in mind that in order to close a position, the selling price of the stock needs to be reasonably close to the purchase price.  Otherwise the writer would end up 'giving back' a significant portion of the cash the holding had previously generated.

THE COMMENTARY:  Any time the SysCW TDS or $CA strategy is used there must be an existing position.  The discussion will begin with a look at the existing position as maintained in the Position Tracker.

The position was established back in 2004 with the purchase of 200 shares of DNDN.  Other than the first option position, note that every call sold against this stock has expired. If you took a look at a one year chart of this stock you would see that it has been trading between $4 and $5. The recent trend has been up, which is why the May $7.50 call was sold on January 24, 2007.  With a $10.94 cost basis, we surely do not want to sell this stock for less than $10.

Let's be honest; other than one spike above $11 in November 2004, this stock has been depressed since it was purchased! That is the bad news.  The good news is that even though the price has not cooperated, the premiums generated to date of $1,371.45 represent over 62% of the investment.  From the 'asset' point of view, this asset has generated 62.70% in about 32 months.

Each year the writer looks for opportunities to create 'paper' losses in order to reduce the realized capital gains.  With this in mind the writer sees an investment of $2,187.00 and a current value of about $1000 (as of Feb. 21, 2007). What this indicates to the covered writer is that if the stock can be purchased for $1000, held for thirty days, and then sold for $1000, a $1187.00 loss could be created by using the standard FIFO costing method.

That was one thought.  The other was this stock just seems to be stuck in a trading range.  Given that this range is about half the purchase price, the position becomes a candidate for the SysCW Dollar Cost Averaging strategy. Time for a quick 'value' discussion.

Note that the latest option that was sold against this depressed stock generated $110.49, and has a duration of about four months. Now . . . assume that the same amount of cash could be generated for two more cycles to make up a year.  The asset of $2,187.00 would generate $331.47 in twelve months.  So . . . what is that on an annualized basis?  Dividing $331.47 by $2,187.00 yields 15.15%.  Even though the 'value' of the stock is down about 50%, the asset is still capable of generating cash at 15% annually.

Is this far fetched?  Not really, when you consider that the asset has generated 61.34% in the last 32 months.

It is this observation that led the writer to go ahead and establish a TDS position, and Dollar Cost Average the holding at the same time!  Here is the new position, which was established on February 21, 2007.

As a stand alone position, the new holding is exceptional.  If the stock is above $5 in May, the writer could give back the three cents a share difference between the purchase price and strike price.  This would mean that a $5.03 investment would generate $1.52 in three months.  Do the math . . . it's a nice position!

Now let's factor in that $4 has provided resistance for the past year. The $1.55 premium protects this new purchase to below this resistance level. Great, but what happens next?

1. First, one of the goals of this position is to establish a loss.  On March 26, 2007 the writer will begin looking at the feasibility of buying back two of the five May calls and selling two-hundred shares of the stock. The writer simply separates this new position into two holdings.  One that will be closed and one that may be closed.  Data keeping would look like this:

Keep in mind that as soon as the thirty days is passed, and the 200 shares can be closed at a profit, the writer will do so in order to establish the loss.

    2.   Depending on what DNDN is doing in May, the writer can do a number of things with the remaining 300 shares.

•    If the stock is trading below $5 a share, both the $7.50 call on the older shares, and the $5 call on these shares will expire.  The writer will then combine the two positions.  The Dollar Cost Averaging result will be 200 shares at $2187.00 and 300 shares at $1,513.17 or a new cost basis of $7.40. Depending on where the stock is, the writer could then sell a $7.50 call or LEAP against this combined 500 share position.
•    If the stock is trading above $5, but below $7.50, the writer could allow the $5 call to be exercised and then recover the older shares.  Obviously, in order to take this path, the price of the stock would need to be closer to $7.50 than $5.00, which is something that has not happend for over a year.
•    Or, if the price is slightly above $5, the writer could Buy Back the $5 strike price on expiration Friday, then sell five calls the following Monday, given that the $7.50 calls would expire.

This may seem complicated, but it really isn't.  One of these scenarios will probably occur.  The writer already knows what to do under the various possibilities, which is to say . . . it's systematic!  Obviously, there are extremes.  The stock could triple, or the company could go out of business.  Given that these are rather unlikely given the history of DNDN, there seems to be little benefit to adding them to the mix.

All in all . . . this is a very interesting position.

Comments, questions and opinions are always welcome . . . rlcoveru@wavecable.com

The Covered Writer

Tax loss strategies are used in the Systematic Covered Writing process to defer taxes. This is no different than claiming all the deductions possible to reduce your earned income tax liability.  Having said that . . . please verify this process with your CPA .  It is important that your professional advisors are on the same page as your investment strategies.

PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN DNDN 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!

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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 © 2005. All rights reserved.
Revised: 08/03/07