Systematic Covered Writing

 . . . more than just covered calls . . .

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Tax strategies are used in the Systematic Covered Writing process to defer taxes. This is no different that 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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Tax Deferral Strategy Example

THE DATE: December 26, 2006

THE STOCK:  Renovis Inc. (RNVS) is a development stage company focused on biopharmaceuticals to treat pain, trauma and stroke, and neurodegenerative diseases.

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 realized gains. The idea is to maintain 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.

END of 2006: As 2006 comes to an end, last minute paper losses are created even though the TDS position itself ends in a small loss.  Keep in mind there are two views to be considered.  One is the actual TDS position, which is comprised of a stock holding, and a call option. The other view is how the 'closed' trades are reported to the IRS.  Let's begin this detailed example with the email message that was sent on December 26, 2006 to subscribers.

Email Comments:

The TDS (Tax Deferral Strategy) in the 100k Portfolio was closed this morning.  The trade was ended with a small ($44.92) loss due to the significant realized capital loss ( $5,423.95) that was created by doing so.  The loss is possible because all shares of RNVS have been held for the required 30 days, and the cost basis that is being matched is from the older holding, which corresponds to the first in fist out (FIFO) assignment of stock. 

As far as the IRS will be concerned, five-hundred of the shares purchased on October 24^th were sold today.  As far as the writer is concerned, that position is still active and it was the TDS position that was liquidated. It is unusual to have TDS end with a loss, but because of the significant tax deferral, the writer elected to ‘bite the bullet’ on this one. 

The funds that were used for this TDS can now be put back to work.  The Position Tracker for both positions is provided below as an illustration of how the records are maintained.

The Covered Writer

RNVS was one of several stocks which lost significant value due to phase III trial results. The writer was probably a little over zealous with the Initial Position established in October of 2006. It was one of those 'the stock would have to lose half its value' for the covered position not to work scenarios.  Unfortunately, that is exactly what happened. Keep in mind that when a drug fails to meet expectations, the drop in price is generally after market close, or before open, so it's not like one can exit as the price is falling.

As you can see from the Initial Position below, the one month November calls expired.  The position was then recovered in an effort to generate additional cash.

If one can ignore the value of the stock, which is much easier said than done, this position has already generated over three years worth of premium, based on 15% per year.  What the writer must do is watch the stock over the coming months and be willing to raise the $5 strike price. In the mean time, because this is a taxable account, the TDS strategy is used to derive some 'good' out of this less than favorable situation (based on 'value').

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The principle behind the TDS strategy is rather basic.  By establishing a short term position with the same stock, a covered writer can 'create' a paper loss.  By default, the cost basis of shares that are sold happens to be the first shares that were purchased.  Here is the data for the closed TDS holding that was established in November to take advantage of the lower stock price.

		SysCW   Position Tracker
Historical Data			Closed Position
				Stock	Cash	Total Cash
Date	Strategy	Status	Position	Investment	Generated	Generated
24-Nov-06	Initial TDS Stock Purchase		Buy 500 RNVS @ 3.3188	($1,666.40)
TDS			Renovis, Inc.
24-Nov-06	Initial TDS Call Option		Sell five Jan $2.50 calls @ .90		$436.73
24-Nov-06	TDS Potential	($5,375.70)
26-Dec-06	Buy TDS Calls To Close		Buy five Jan $2.50 calls @ .75		($388.25)
26-Dec-06	Sell Stock  to Close Position		Sell 500 RNVS @ 3.16	$1,573.00	($93.40)
26-Dec-06	TDS Created	($5,423.95)	Net Cash Lost			($44.92)
32	Days

Normally a TDS position is set to end with a small gain, but in this case that was not possible as the position had to be closed by the end of December.   Note the TDS Position was for 500 shares, and that the position closed with a physical loss of $44.92.  This was acceptable due to the magnitude of the realized capital loss that was created.  Below you can see how these closing transactions will be reported to the IRS for the 2006 tax year.

Date	Event	Cost	Proceeds	Gain
24-Oct-06	Buy 500 RNVS @ 14.08	($7,045.43)
24-Nov-06	Sell five Jan $2.50 calls @ .90		$436.73
26-Dec-06	Buy five Jan $2.50 calls @ .75	($388.25)
26-Dec-06	Sell 500 RNVS @ 3.16		$1,573.00
	TOTALS	($7,433.68)	$2,009.73	($5,423.95)

There are two closed equity positions.  Five-hundred shares of RNVS stock and five contracts of the Dec $2.50 call option. As the data indicates, a $5,423.95 paper loss was created using the SysCW TDS technique.  Keep in mind that the original November call options are counted as a realized gain for the 20065 tax year.  This loss more than offsets that gain.

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As positions end with the January expiration, the writer will be looking for establishing TDS positions to be used against stocks like TELK and AGIX for the 2007 tax year.  As the email comments indicated, these transactions took place in the online 100k Portfolio.

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

The Covered Writer

PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN RNVS 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: 02/05/07