Paid off house with tax free money from covered call selling

[Roland of Gilead]

We are selling our house in 2015 and going homeless for a really cheap lifestyle.  We currently are right at the level of standard deduction/itemized deduction for a married couple.  Our home mortgage had a balance of $48,000 from a $200,000 3.625% loan.  I had $40,000 in an emergency fund (earning close to nothing) and wanted to pay down the house.

I realized I could sell Jan 2016 out of the money calls on a range of stocks and indexes in our taxable brokerage account.  This generated $28,000 of cash with no taxes due until 2016 (unless called away early of course).  I used this money plus $20,000 of the EF to pay off our 3.625% loan which in my mind is equivalent to buying a 1 year bond with a 3.625% tax free return (because we don't itemize).

This will drop our EF down to $20,000 but every month we will have $1900 more in cash flow from not making a house payment (payment is $2300 but the $400 goes to escrow for taxes/insurance).

If the markets go crazy bonkers and for some reason the shares are called away before 2016 I will owe taxes sooner, but I will have the funds from the sale of the shares to pay the taxes.  Our taxable account would have increased by roughly 25% if this happens so it is not a bad scenario at all.

If we are not called early on the shares, we will end up not owing any taxes on the covered calls because our 2016 income will drop to near zero (from currently the 33.8% bracket).

Win win?

[marty998]

We are selling our house in 2015 and going homeless for a really cheap lifestyle. 

Now when you say homeless. How did your marriage survive that discussion?

[Roland of Gilead]

We are selling our house in 2015 and going homeless for a really cheap lifestyle. 

Now when you say homeless. How did your marriage survive that discussion?

Pretty easy, it was my wife's idea.

[Atlas92]

I think the idea of selling covered calls can at times be a good strategy, particularly in a Roth IRA with equities you are looking to hold onto long term. In this case a market correction wouldn't be too concerning and a call of the option in an up market wouldn't trigger a tax liability.  Anyway the numbers in your post seem too good to be true.

If the markets go crazy bonkers and for some reason the shares are called away before 2016 I will owe taxes sooner, but I will have the funds from the sale of the shares to pay the taxes.  Our taxable account would have increased by roughly 25% if this happens so it is not a bad scenario at all.

If your taxable account would increase by roughly 25%, then I could only assume your OTM calls were sold at 25% above the cash close.  Looking at the SPY, Jan 2016 OTM calls 25% above the cash close would be roughly 230 call.  This has a premium of roughly $1.00.  So, the underlying stock value of $18,600 will generate $100 in premium, or just about 1/2%.

I realized I could sell Jan 2016 out of the money calls on a range of stocks and indexes in our taxable brokerage account.  This generated $28,000 of cash with no taxes due until 2016 (unless called away early of course).  I used this money plus $20,000 of the EF to pay off our 3.625% loan which in my mind is equivalent to buying a 1 year bond with a 3.625% tax free return (because we don't itemize).

Now, if you can generate $28,000 at a 1/2% it would mean your equity position was roughly $5.6M.  If you have 5.6M in an equity position $28,000 is change in the couch.  I realize you may not be using SPY calls so the premiums could be different, but it would have to be one hell of a volatile position to generate those sort of premiums at a far smaller equity position.  For instance VXX will generate 11.50 of premium for a Jan 2016 OTM call 25% above cash.  So you'd be looking at $1150 for every $4450 in underlying equity.  So you'd only need about $108,000 in the equity position for your numbers to work, but I assure you this would end in heartache.  Anyway I'm not trying to call you out, I'm just really interested in options and this doesn't add up to me, please advise me if I'm missing something here.

[Nords]

So you'd only need about $108,000 in the equity position for your numbers to work, but I assure you this would end in heartache.  Anyway I'm not trying to call you out, I'm just really interested in options and this doesn't add up to me, please advise me if I'm missing something here.

Usually the issue is that covered calls don't return enough reward for the risk of getting exercised, especially over long durations where average volatility is lower but the variations can reach black-swan highs.  Maybe he would've had higher returns if he'd held on to the equities for another 18-24 months, but he's raising cash now.

Of course selling covered calls in a Roth IRA would avoid a lot of taxes (I didn't even realize that was available) and the OP may not care about being exercised.

[Roland of Gilead]

A couple of points.

1)  I have some carryover losses from tax loss harvesting in 2009 and since, about $15,000.  $3000 can be claimed against 2014 and 2015 income but that leaves $9,000 on the table we may not use up if our income drops below taxable levels in 2016 (which it will).

2)  I wrote the calls mostly on volatile stocks (and some indexes) like Apple.  A Jan 2016 $630 call on Apple has a premium of $26 with the current stock price of $520.  This represents a 5% return.  If called away, the total return is $136/$520 = 26.15% plus another 4% for dividends between now and 2016.  If you get an average of 5% then you only need to write calls on $600,000.

[EscapeVelocity2020]

Selling covered calls is a good strategy if you feel overly concentrated in equities, or a specific stock, and ultimately plan to sell down but want to lower the risk of continuing to hold the equity over the option duration.  I'm worried that you are getting a bit too fancy using the strategy to paying off the house, the two decisions should be taken independently.  Either you feel that equities will decline and you have enough confidence to buy bonds (pay off a low cost mortgage early) or you have a good balance between equities and an 'inverse bond'.  I'll admit, I'm a big fan of holding a mortgage, even if you plan to sell the house before it's paid off.  Sometimes the urge to 'just do something' can be misleading.

If you feel strongly that you need to lighten up on equities and pay off the mortgage is the best return on your freed up cash, I'd take some middle ground selling some equities (you have some offsetting losses) and remove the guess work out of the timing of tax and the potential of being stuck holding a stock for the duration of the covered call, if the market or stock goes on a tear or tanks...  You are adding risk when it sounds like you have a good portfolio that has recently done well and want to lower risk (and pay off a small, fixed liability) IMHO. 

[TennisPro]

I agree with EscapeVelocity2020.

This strategy has almost all of the risk of owning AAPL outright.  You may be letting your desire to get a chunk of cash upfront when you sell the call, and your desire to harvest your tax loss, influence your thinking.

Owning a total stock market ETF like VTI is less fancy.  You can still harvest your tax loss carryover after you have a gain in VTI.  Or, if you want a 3.625% tax-free bond, that is what you are essentially getting with every dollar you use to pay off your mortgage, instead of having it invested in any of these strategies.

Lastly, if you still favor the idea of a covered call, consider a naked put instead, since the premiums are generally two to three times greater for the equivalent percentage price change risk.

[Nords]

Lastly, if you still favor the idea of a covered call, consider a naked put instead, since the premiums are generally two to three times greater for the equivalent percentage price change risk.

Ouch!

The penalty for being exercised on a naked put (especially when trying to pay off a mortgage) might not be compensated by that higher price...

[S0VERE1GN]

www.unclebobsmoney.com

great information on utilizing calls for consistent returns, and how to minimize risk.

[Roland of Gilead]

Lastly, if you still favor the idea of a covered call, consider a naked put instead, since the premiums are generally two to three times greater for the equivalent percentage price change risk.

Ouch!

The penalty for being exercised on a naked put (especially when trying to pay off a mortgage) might not be compensated by that higher price...

I think he meant cash secured put.  I would never sell a put if I was not willing to own the company at the put price, therefore I would need the cash ready at hand if assigned shares.

I see dividend + call premium on certain stocks to be higher than the corresponding put, plus I have a lower basis in some of these and selling the call lets me grab some money without selling shares and generating taxes.

Anyway, I can't go far wrong here.  Either we get another 2 years of roaring market, I make about $160,000 in profit and pay $50,000 or so in tax or we get a flat market and I pocket all of the covered call premiums and pay no tax.  The last case in which the market drops I am 5% ahead of every buy and hold investor.

[Freckles]

It's like reading a foreign language.  What on earth are you people taking about?  Selling covered calls?  Being exercised?  On a naked put???

So confused.  :/

[Nords]

It's like reading a foreign language.  What on earth are you people taking about?  Selling covered calls?  Being exercised?  On a naked put???

So confused.  :/

Here's the textbook:  http://www.free-ebooks.com/book/739/options-a-strategic-investment

[Roland of Gilead]

It's like reading a foreign language.  What on earth are you people taking about?  Selling covered calls?  Being exercised?  On a naked put???

So confused.  :/

If a naked put comes into the room, you cover your call or risk getting exercised (unless you like to straddle!)

[beltim]

It's like reading a foreign language.  What on earth are you people taking about?  Selling covered calls?  Being exercised?  On a naked put???

So confused.  :/

Here's the textbook:  http://www.free-ebooks.com/book/739/options-a-strategic-investment

Is it just me or does that website look like copyright violation central?

[TennisPro]

Anyway, I can't go far wrong here.  Either we get another 2 years of roaring market, I make about $160,000 in profit and pay $50,000 or so in tax or we get a flat market and I pocket all of the covered call premiums and pay no tax.  The last case in which the market drops I am 5% ahead of every buy and hold investor.

I still like my original idea of buying a low-cost index, like VTI, instead.

You may do well with AAPL.  You may do well with your overall portfolio.  You may do well selling calls against your portfolio.  But, over a ten year period, a fancy portfolio has somewhere between a 17% chance, and a 0.6% chance, of beating a not-fancy portfolio, depending on which studies you look at.

http://www.rhsmith.umd.edu/faculty/rwermers/FDR_published.pdf

http://www.institutionalinvestor.com/Article/3256074/Beating-the-Market-Has-Become-Nearly-Impossible.html?ArticleId=3256074&p=6


And, Nords, of course you are right.  Naked puts, especially when not cash-secured, can smack you in the nuts. 

Also, after looking at AAPL specifically, Roland of Gilead is right, that the premium on calls plus dividends, is nearly equal to the premium on puts, for strikes the same percentage otm.  That is not normal, and it generally means that a lot of people think AAPL is going up, and are bidding up the calls.

[TennisPro]

If a naked put comes into the room, you cover your call or risk getting exercised (unless you like to straddle!)

I like mi puts like I like mi ladies, naked and far away from the money.    ;-)

[EscapeVelocity2020]

I still like my original idea of buying a low-cost index, like VTI, instead.

...But, over a ten year period, a fancy portfolio has somewhere between a 17% chance, and a 0.6% chance, of beating a not-fancy portfolio, depending on which studies you look at.

http://www.rhsmith.umd.edu/faculty/rwermers/FDR_published.pdf

http://www.institutionalinvestor.com/Article/3256074/Beating-the-Market-Has-Become-Nearly-Impossible.html?ArticleId=3256074&p=6

Thanks for the links TennisPro, you are much more sophisticated than me.  I downloaded a brick when I started trading options and pretty much gave up while I was ahead.  Now that I know naked positions can lead to an opportune straddle, maybe I'll get more enthusiastic...  then again, I'm of the opinion that Wall St. is eventually going to f#&k me if I think I can beat the house consistently...  Only Warren Buffet gets to do that-
http://blogs.marketwatch.com/thetell/2014/02/26/new-deal-for-warren-buffett-and-bank-of-america/
(just one example...)

[EscapeVelocity2020]

Anyway, I can't go far wrong here.  Either we get another 2 years of roaring market, I make about $160,000 in profit and pay $50,000 or so in tax or we get a flat market and I pocket all of the covered call premiums and pay no tax.  The last case in which the market drops I am 5% ahead of every buy and hold investor.

This is the bit that I get confused about.  Can you give your example, such as, if AAPL doubles from $500, the option is exercised in 2016 at $1,000 per share.  The 100 share position worth $100,000 is then handed over to the call buyer, which originally cost $50,000 and got an additional 10% premium for selling the calls, so an additional $5,000.  You are right that you made $55,000 (minus the initial stock purchase price), but someone else made $50,000 increase by paying $5,000 for the call. 

Also, if the stock is cut in half while you are holding it, you end up losing money at some point, except I guess you say that you are buy and hold which exempts this from bothering you.  But what if AAPL starts diluting shareholders by issuing new shares or replaces the CEO?    Ultimately, when a stock is crashing, it's nice to have a stop-loss order somewhere above your buy in, or be able to sell half at market if rumors look likely to become news...

I hope that AAPL stays flat until 2016, or when it goes up you buy some cheap puts, but this is why I stay out of fancy-pants investing.  Way too much time and risk (and associated timing and emotion), but I'll probably get some fun money back into trying to exploit Black-Sholes on my holdings someday, I always did prefer to take part in the sophistication that lead up to a financial bubble/collapse, as opposed to being an innocent bystander. 

[Roland of Gilead]

Well, examine the 100 share position where you write one Jan 2016 call against it.

First, I purchased these 100 shares at less than $500 but you can go with a $50,000 cost basis in the shares to make calculation easier.  If I sold the shares today for $530 I would owe tax on the $3000 gain.  If I write a Jan 2016 $630 call for $27 (current price with Apple at $530) I immediately get $2700 and do not owe any tax until 2016 or until called away.  I still collect ~2.3% per year dividend payments on the 100 shares.

Take your example now of Apple doubling to $1000 a share.  My shares get called away and I get paid $63,000.  I also collected about $2,000 in dividends during the holding period and I have the $2700 from selling the $630 call.  So the total amount I now have is $67,700 and my cost basis was $50,000.  This is a gain of $17,700 or around 35%. 

[EscapeVelocity2020]

Cool, should've paid attention on the first post!  Got distracted by the 'only $600,000'. Hope it all goes well.

[Roland of Gilead]

Cool, should've paid attention on the first post!  Got distracted by the 'only $600,000'. Hope it all goes well.

Hmmm, yes well, oops.  Apple just exceeded earnings and announced a 7:1 split.  I guess I will have to settle for 35% profit, but hopefully I will not get called away until 2016.

[EscapeVelocity2020]

Yeah, just saw the Wall St. Journal headline.  Your 'luck' and timing seems to be similar to mine.  My guess is that the option will continue to trade until the time premium gets smaller.  Or AAPL stays at or below 90 for a couple years, yeah?

[EscapeVelocity2020]

Any updates?  Did the options get exercised?  Just interested to know what happens with long duration options when they are in the money, I would think they just get traded until closer to expiration...

[Roland of Gilead]

No, they did not get exercised.  I doubt they will for quite some time unless Apple raises the dividend to a level that makes it desirable for the call holder to want to capture the dividend.  It is my understanding that the options go into a sort of lottery basket and it is random chance if your shares are called away earlier.   I have only had it happen once, and this was just a week before expiration.

[Alex239]

Roland, I've been learning about options trading from the guys at TastyTrade.com since about January. I swear you sound just like Tom in my head.  From what I gather you are doing exactly what they teach on the show which is defining your risk. Selling a covered call in your case allows you to limit your risk but you are also limiting your possible gains. They talk about managing winners. Its THE MOST important part of their trading style.  Are you a student of tastytrade?

*Disclaimer, i don't work for tastytrade i'm just really impressed by their ability to teach sounds principles and get me excited about options trading. Its generally regarded as too complex and risky but they make a sound case for a different way of trading options.

If a naked put comes into the room, you cover your call or risk getting exercised (unless you like to straddle!)

I like mi puts like I like mi ladies, naked and far away from the money.    ;-)

Tennis pro! Are you Tony Batista?!

[Roland of Gilead]

I don't follow any particular trading style or school of thought except at the end of the day I like a profit.

Managing risk is important.  It is one reason I will not touch 10 year bonds that pay 2.5%.

[Alex239]

I don't follow any particular trading style or school of thought except at the end of the day I like a profit.

Managing risk is important.  It is one reason I will not touch 10 year bonds that pay 2.5%.

Roland, I encourage you to give them a listen. Thats exactly what they do, keep it simple and make a profit. I bet you would find some great insight or at least validation for what sounds like a very similar style.