I recently started writing puts for income on a large chunk of my savings.

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 started by following Fool's Pro and Stock Advisor to learn the basics of put writing. Soon I decided to use the same stock information and a little more risk to create a bit of monthly income.

The only potential problem I can see is a capital gains tax. Am I looking at getting killed at the end of the year? Would it be smarted to use this technique under my brokerage's Roth account?

Any thoughts are appreciated.

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.

Patzer

Yep, you are understanding what Im doing. I am glad you do not see a serious tax penalty with this type of trading. I think the reason I did not ask about the issue of getting put shares of a company that just went into the toilet was that I had considered it and decided I was going to accept the risk.

This is by no means because I think I can time or outsmart the market or investors who actually know what they are doing, but because I presently have a good income but that will change soon. Due to my age I dont have 40 years of compounding to prepare for my retirement. I have to catch up. I have to take some risk.

The BP fiasco is a perfect example of what you are talking about. I think the only thing I can do to lower my risk while using puts and calls this way is to continue to invest in solid companies and in several different companies at a time, instead of only one or two.

Thanks for your input.

caburke37:

I'm sure you already know this, but there's no harm in repeating.
Since this is an IRA account, you must have enough cash/equity in the account to cover the full price of the purchase, should the shares get put to you.

Cheers!

Actually, I have only been using my margin account and only been considering using the IRA account. I was advised by another Fool that you cannot write naked puts in an IRA account.

Thanks for replying!