Covered Calls – In Or Out Of The Money?

What strike proximity works best for covered call writing?

The answer depends on several mitigating factors:

  1. What is your basis in the underlying? If your basis is far below the strike of the call, you have to determine whether you want (A) current income while keeping the stock, or (B) a sale of the stock.

If you want current income, but do not want your underlying to be called, an out-of-the-money call makes sense. If the stock price remains below the strike, you will not be exercised and once the call expires, you are free to write another. If the underlying price begins moving upward toward the strike, you can buy to close the call or roll it forward.

If you are trying to sell the stock but with a profit in stock and extra premium income, consider selling a call at or in the money. This sets up one of two scenarios. If the underlying price falls, the call expires worthless and it is just extra income, and you can then write a new call. If the underlying price rises above the strike, you can accept exercise and enjoy the combination of a capital gain on the underlying and profit on the short call as well.

  1. Does ex-dividend date arrive before expiration? If you are hoping to write a series of calls and gather the income over time, keep an eye on dividend dates as well. Early exercise is a very unusual event even for in-the-money options, with one exception. The period right before ex-dividend date is the second most likely exercise period.

So if your call goes in the money right before ex-dividend, it could get exercised. This is not a certainty; assignment is random for early exercise, but be prepared as it could happen. Exercise and loss of the current dividend are possible, so this has to be acceptable. Otherwise, close the call or roll it forward so you can still earn your current dividend.

  1. Is there a possible tax consequence? If you sell a call in the money, make sure you know the rules for qualified and unqualified covered calls. If you have owned the underlying less than one year, selling a call too deep in the money could result in an unexpected short-term capital gain, even if it happens after a full year has passed.

Even without considering the qualified status of the covered call, the capital gain question also comes up in every case. If your option is exercised within one year of your buying stock, the capital gain will be short-term; and the option will also be treated as short-term income.

The decision to sell covered calls at one strike or the other relies on your basis in the underlying, what you hope to accomplish by selling the call, and a full understanding of the tax consequences.