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ESPP Covered Calls

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The basic principles of this investment strategy are:

Sell covered calls against the shares of stock you purchased through your employer’s ESPP.

  • This puts cash in your account that you can use to invest elsewhere or pay expenses
  • Ensures that if the stock is sold, it is sold for a profit higher than the discount offered by your company

Collect the dividends from the shares (Assuming your company pays dividends)

  • This provides money to be invested elsewhere or pay expenses in addition to the premium from the covered calls

Try to hold most shares for more than a year

  • I generally pay less taxes on the actual sale of the stock because of this
  • I am fine with paying higher taxes on the options as it is a smaller portion of the account
  • I am stuck paying the marginal rate on my discount on the stock

I know a lot of other folks aren’t comfortable with this strategy as options are confusing and they seem like something that day traders should be using or require a lot of research. To be honest, I get that line of thinking, I didn’t even know what options were (let alone a covered call option strategy) when I was using the ESPP at Washington Mutual. I just wish someone would have taken the time to explained it to me. Yes I held all the WaMu shares and lost plenty of money – I guess if we don’t learn from other people’s mistakes we learn from our own. Not that I want more people selling covered calls and reducing the small premium I earn on mine…

So here is the deal with the covered call strategy. It is a very simple and safe way to leverage a larger long term position for short term gains. When you have a larger position in a stock as usually happens for people who start using a corporate ESPP and aren’t sure how to manage it, there is a desire to see some of that money sooner and the fear that if you sell now the stock will go up or the taxes will be too high. Certainly if the company pays dividends you get some money and if you don’t reinvest the dividends you can use that cash for spending or investment money. Selling covered calls allows you to go one step further and strategically plan to sell a significant portion of your holding at a reasonable profit. I’ll briefly walk through the strategy starting with what the covered calls are, what strategically planning your sale prices means, and what benefits there are to the plan.

Generally speaking options are a contract that allows a party to buy or sell a defined number of shares at a specified price. Like most any contract the option contract is good until a specific date. Usually the contracts expire on the third Friday of the month – to be sure of the date though there is a nice CBOE Options Expiration Calendar that you can reference. When you are selling a Covered Call Option Contract, you are selling to another party a contract that guarantees them the right to purchase from you the equity that the option is for at the specified price between the date of sale and the expiration of the contract. Sorry, that was a mouthful… As an example, if you sold me a contract today that allowed me to buy 100 shares of Microsoft stock for $30 and the contract expired on 2/18/2012, I would have between now and the 18th of February to purchase the Microsoft stock from you for $30 per share. For this option, I would have to pay you a premium today that you pocket regardless of whether I exercise my option or not. We’ll say that I pay you $0.14 per share for the contract – That is $14 that you get to keep minus any taxes and transaction fees for that one contract. I lose $14 plus any transaction fees for the privilege of owning this contract that you sold me.

Am I really spending all this time explaining how you can make $14? After the first few ESPP deposits into your account, most of us don’t have enough shares to sell 100 contracts (10000 shares) to pocket $1400. There is more to the strategy than the $14 if you care to bear with me through the second part. If you purchased the shares at a 10% discount today, you paid $25.43 per share. You could easily sell those shares today and earn $2.83 per share in profits. Of course you pay the standard rate that is applied to the discount between the price of the shares and the discount you received in the ESPP (which happens to be your marginal rate). Using rudimentary calculations and assuming a 25% tax bracket, you would have your roughly $2.12 to spend on other investments or that new Ford so that you can check out the Sync. The alternative would be to hold the shares today, sell a covered call and earn the $0.12 per share (subtracting the 25% short term capital gains taxes – remember the short term capital gains taxes is generally your marginal tax rate). In both cases we are assuming transaction fees are zero. So you lose out on $2 per share today for some undetermined amount in the future. This means it will take a lot longer to get that Ford and you’ll have to go in and sell more covered calls every so often.

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With your 100 shares, let’s say that you sell 1 covered call contract every other month for the entire year. To make things easy, let’s also say that you will sell the covered calls at strike prices that are $1-2 above your purchase price. This means that if you sold me that contract today, you would be back at fidelity selling covered calls in March (or late February) for an April expiration with a strike price of $30 (keep in mind that the strike prices are usually round numbers, although some are halfway between two round numbers like $27.50). This continues in May, Jul, Sep, & Nov. By December you have earned a whopping $71.40 after short term capital gains taxes! Add to those big earnings the dividend (4 times per year) of $60 after taxes. Now you are up $131.40 on your investment of $2542.50. Ok, so that’s barely over half of 10% – I know, you bought the stock in the ESPP so that you could get the 10% bonus right?

Fine, once your year is over you have two choices sell immediately or lower the exercise price of the option contracts you are selling. If you lower your option strike price to $29 or $0.50 over your purchase price you will have a higher premium (for example $0.36) so you get to pocket that and then when your option contract is exercised you sell all the shares for $29. Now you have earned the $131.4, the $27 for the last covered call you sold, & $303.88 for the sale of the stock. So what does this look like in comparison?

Well assuming you are paying a marginal tax rate of 25% (I’m not making judgements on what your real rate is) and assuming you are paying Long Term Capital Gains. You have the opportunity to nearly double your profits over a short term sale when you hold for the year, sell covered calls, & collect the dividend. This is just on the basis of 100 shares and a specific strategy of selling the covered calls every two months. I did leave out the extra premium for the covered call after the year was up. Assuming you wanted to sell in January of the following year, you would want to sell the current month covered call (the January covered call) which usually will be worth a penny or less.

Covered Call Sell Immediately
Rev. From Sale $       2,900.00  $                 2,825.00
Taxes on 10% ESPP discount (25%) $             70.63 $                       70.63
Taxes on profit over ESPP discount (15%) $             11.25
 $       2,818.13  $                 2,754.38
Covered Call Premium $             84.00
Taxes on Covered Calls $             21.00
 $             63.00
Dividends $             80.00
Taxes on Dividends $             20.00
 $             60.00
Cost of ESPP $       2,542.50  $                 2,542.50
Net Profit $           398.63  $                    211.88

I have talked to a number of people about this strategy and they always tell me that they earn more money selling immediately, that it is too complicated, or that they can earn a higher return somewhere else. The other one I hear is that the markets are efficient and that this is impossible. Maybe they are right, but on a tax adjusted basis the covered call strategy has the possibility of returning 15% for the year over the immediate 8.33%. Maybe I’m missing something and there are some other opportunities that I just don’t know about to get these kind of returns. Personally I take my profits when I sell and purchase other strong stable companies that give me dividends that I can sell covered calls on… that way I am diversified and maintain strong returns.

I will warn that there are some caveats, there are no easy ways to make money….

The first is a positive one. Sometimes the stock is called away early and you have to sell before the year is up. Sometimes that strike price sneaks up on you and suddenly you are stuck selling your stock. That sucks that you pay the higher tax rate (but assuming this happened in February on our $30 strike price contract you would have $12 + 343.13 in after tax profits so it is still a better deal than selling immediately.

The second is a negative one. Sometimes the price of the stock is less volatile and just slowly goes down. In these cases the premiums on the strike prices that are appealing disappear and there aren’t any good contracts that you can sell for a profit after transaction fees. In these cases you may be holding the stock for the whole year and only sell one covered call. You still get the dividend and you may not be able to sell it immediately after the one year holding period considering it may drop below the original price and even below your discounted ESPP price. In these situations you may end up accumulating a lot of shares, in which case you start to earn a lot more from selling the contracts as you can sell 10 contracts (1000 shares worth) for $.05 and feel pretty good that you can cover transaction fees with your $50 gross earnings.

The last thing!

To find the option contracts are available (what their names are, their prices, etc.) use the CBOE website. Assuming that you are using a big firms ESPP, you will be doing the transactions at Fidelity. To turn on covered call writing in Fidelity (this is not turned on by default), you will have to go into the configuration of your account under margin and options and request option trading. There will be a lot of hoopla about how experienced you are and such. What they are trying to scare you out of doing is turning on options trading or margins with no knowledge of what you are doing. Just be honest on the forms but only select that you want to start “writing covered calls” (that means selling other parties a contract to buy your stock at a specified price). They will turn on the configuration without much trouble and you can muddle your way through the rest.

I am not going to make any claims that you will actually be able to get comparisons exactly like the chart above (I will tell you that the two caveats above play a major factor on the whole strategy). I personally do better than the “sell immediately” strategy using the “covered call strategy”; however, your mileage may vary.

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