Financial options can be very useful for generating additional income and improving overall investment returns.
There are many option products and strategies available. Some of these can get very complex, and some are very risky also.
The focus of this post is on basic put and call options. More specifically, we will discuss the merits, risks and tax implications of selling (or going short) these options in order to generate income.
For simplicity, the following discussion ignores the impact of broker commissions. Depending on the broker you use, the impact to the numbers we discuss should generally be minimal.
The Put option
Let’s start with a basic definition.
A put is a type of option that gives the buyer of the option the right to sell a number of shares of stock to the seller at a certain price (the strike price) by a certain time (the expiration date). The seller of the option in turn is obligated to buy the shares of stock from the buyer if the buyer so decides. The buyer pays the seller a fee (called a premium) for this right.
Generating income from selling put options
A good way to generate income is to sell puts on stocks you are thinking of buying anyway. For example, let’s say you are interested in buying Intel (INTC). However, you think it is too expensive at the current price of around $38. You would be comfortable, however, buying into Intel at let’s say $35.
That’s where the put comes in. You could sell an April put for $.36/share. If Intel falls to $35 or lower, then you buy the shares at $35. If Intel never falls that low by April, then you simply pocket the option premium and move on.
What’s the return on that investment? The premium of $.36 comes out to $1.44 (4 X $.36 = $1.44) annualized (since the option only goes for about three months – January to April). Divided by the share price of $38 you made a 3.8% return on your investment. Again, not considering commissions.
That’s not a massive return. However, you were thinking of buying Intel anyway, and you were comfortable paying $35/share. So you’re essentially picking up 3.8% on that cash you are waiting to deploy – instead of making next to nothing holding regular cash.
What are the risks?
The main risk of selling puts is that you might end up having to purchase stocks which you are not comfortable holding, or at least not comfortable holding at the price you were forced to pay.
Here are a few ways to mitigate these risks:
- Sell puts only on stocks you are considering owning anyway
- Go for a strike price you consider to be an attractive entry point
- Ensure that you have the cash available to cover the put
- Make sure that the potential purchase of the stock does not upset your overall target asset allocation
First of all a disclaimer. Specific tax implications of course depend on individual circumstances, and could therefore vary from one person to the next. What follows is merely intended to provide a basic guideline.
The tax treatment of the premium you receive from selling a put option depends on whether the option is exercised or simply expires.
- The options are exercised. In this case your tax basis in the stock is lowered by the amount of the option premium. So you end up deferring the taxable event until you sell the stock. Depending on your holding period, the premium could end up being taxed as either long-term or short-term.
- The options expire. In this case the premium you received is treated as a short-term capital gain.
The Call Option
A call option is essentially the reverse of a put option.
The call option gives the buyer of the option the right to buy a number of shares of stock from the seller at a certain price (the strike price) by a certain time (the expiration date). In turn, the seller is obligated to sell the shares of stock to the buyer if the buyer exercises the option. Just as above, the buyer pays the seller an option premium for this right.
Furthermore, we will discuss “covered” calls only in this post. A covered call is simply a call you sell on shares of stock that you already own. Let’s take a look.
Generating income from covered call options
Again, let’s go through an example. Let’s say you own shares of Intel (INTC), and you think at $38/share they are getting kind of expensive. You might be interested in selling if they hit $40.
To generate a little extra income in the meantime, you could sell a covered call. The April calls are selling for $.34/share. If Intel trades at or above $40 before April, then you could be called to sell your shares at that price. If Intel never hits $40, then you just pocket the option premium.
By selling this call, you generated an extra 3.6% (annualized) on your Intel shares. The premium of $.34 comes out to $1.36 annualized (since the option only goes for about three months). Divided by the share price of $38 that comes to 3.6%.
Again, not a huge return. But it gives you a little extra cash flow from shares you already own.
What are the risks of selling a covered call?
The main risk of selling covered calls is that you limit your upside on the stock you are holding. In the example above, you are limiting your upside in Intel to $40. Should you get called and Intel trades up to let’s say $45 later on, you would not participate in that additional gain.
Of course, if you hadn’t sold the call, and simply sold Intel outright when it hit $40, you’d be in the same boat. So the main risk mitigation here is to make sure you’re comfortable with selling at the strike price. If you’re not, then you’re simply gambling that the stock never hits the strike price.
Again, your circumstances may vary, and that could affect how these transactions are treated on your tax return.
However, on a high level, the tax treatment of covered calls is very similar to that of the puts we discussed earlier.
- If the call is exercised, then your tax basis in the stock is lowered by the amount of the option premium. So upon the sale of the stock, depending on your holding period, the premium could end up being taxed as either long-term or short-term.
- If the call expires, then the premium you received is treated as a short-term capital gain.
Selling puts and covered calls can be a relatively low risk way of generating a little extra income. This could come in handy as a way to provide extra cash flow during retirement, or to simply increase investment returns on your way there. Whether it’s something you might consider depends on how actively you want to manage your portfolio.
And of course, any option strategies (even the ones described here), carry risk. Before trading options, you need to fully understand the risks as well as the opportunities.