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Financial Planning / Tax Strategies


Subject:  Re: Put income and capital gains Date:  7/30/2010  11:03 AM
Author:  Patzer Number:  110765 of 122295

Using short puts (30-60 days) I am making $1500 or so a month in extra income. I don't worry about getting the put "put" to me because I invest in good (Fool recommended)companies and due to the immediate put income made I can immediately write covered calls at a lower (out-of-the-money) strike on any contracts I just bought, making more income, and at a price that almost guarantees the sale. I really don't want the stock, just the income.

Then I turn around and do it again the following month.

My concern is if this is a reasonable technique - why havn't I already read about it in the Fool?

I think you mean in-the-money covered calls, since you turn around and say the price almost guarantees the sale. If I understand you correctly, the process is something like this:

XYZ is trading around $50. You sell puts at $45, pocketing the premium. If XYZ trades below $45 and you get the stock put to you, the plan is to sell covered calls at $40 to get rid of the stock. Do I have that right?

There is no particular tax issue to make this a bad idea. As long as the stock is never put to you, the expired puts give you short term capital gains, you fill out a lot of lines on Schedule D and Schedule D-1, pay your taxes, and are happy with the profit.

The problem is Black Swan events in the market. Say you sold 45 strike puts on XYZ when it was trading at $50. While your puts are open, news breaks that XYZ had an oil rig blow up, or had the CEO indicted for fraud, or the entire industry melted down because it didn't price loans correctly, or the company chose to burn all its cash acquiring a bad business, or whatever. The price drops to $28 overnight. You are put the stock at $45, and can't unload it for more than $30 even including the premium for the covered call, because things changed while you had the put outstanding.

That's why people shy away from this strategy. It can go on for a long time making a steady income, then something changes and wham! You have a trading loss that wipes out years of profit on the open options. You do get a reduce AGI and reduced tax liability from the trading loss, but it's cold comfort to pay $2,500 less in taxes because you lost $10,000.

Now, you may be smart enough to do this at prices that compensate you for the Black Swan events and turn a profit long term, anyway. I'm not that smart, and TMF thinks no one is that smart. (I'm less convinced that no one is that smart; it's enough to know that I'm not.)

This one is not primarily a tax issue. It's primarily an investment/trading issue.

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