Tip 2: Don’t panic if you’re assigned.
If you’re called upon to deliver stock, it can come as a surprise. Some covered call writers worry about losing a long-held stock position this way. But you have more choices in this situation than you may realize.
Let’s say you’ve bought 100 shares of XYZ per year over the last five years, and with each new purchase, the price was higher than the previous one. Then you write one covered call against your holdings. If you are assigned, you can choose the specific lot of shares you wish to deliver from all shares of XYZ that you own. The best course of action may be to deliver the most expensive shares of XYZ you purchased more recently, and keep the less expensive ones you had purchased earlier. That way, you can avoid triggering a large tax bill due to capital gains on your stock. Be sure to seek the advice of a tax professional when making decisions like this.
If you’d rather not let go of any of the stock you’re holding, that’s okay. It’s possible to buy the stock on margin in the open market and deliver those shares instead. This will give you better control of the tax consequences and your long-term positions. However, take into account that if you want to deliver newly acquired shares you’ll need to anticipate your assignment and buy the shares in advance of receiving the assignment notice.
Furthermore, buying stock on margin has its own risks. Margin is essentially a line of credit for purchasing stock, for which you make a minimum down payment and pay your broker an interest rate. If the market moves against you suddenly, you may be required to quickly add to this down payment in what’s termed a margin call.
Tip 3: Know in advance what you’ll do if the stock goes down.
You’d typically write a covered call on a stock on which you’re bullish in the long-term. If the stock goes south, it helps to have a plan in place. After all, nobody likes it when stocks go down. But once again, you have more choices than you think. Contrary to what many investors assume, selling a call doesn’t lock you into your position until expiration. You can always buy back the call and remove your obligation to deliver stock.
If the stock has dropped since you sold the call, you may be able to buy the call back at a lower cost than the initial sale price, making a profit on the option position. The buy-back also removes your obligation to deliver stock if assigned. If you choose, you can then dump your long stock position, preventing further losses if the stock continues to drop.