Covered Call Strategy Was Not Trading

November 14, 2013
By Kaye A. Thomas

The tax law differentiates between investors and traders. The tax rules that apply to traders are generally more favorable, but only a tiny percentage of all the people who buy and sell stocks and other securities satisfy all the requirements for this treatment. A recent case raises the question whether a taxpayer pursuing a covered call strategy can qualify as a trader.

The strategy

A covered call strategy involves selling call options (that is, options to buy shares) on stock you own. For example, you might own 1,000 shares of IBM and sell 10 option contracts (100 shares each). You receive money for selling the options (called the option premium). If the stock price stays about the same or goes down, the option will expire unexercised and you get to keep the option premium. You also keep the stock, and any dividends paid during this period, so you’ve made out better than someone who merely held the stock during this period without selling a covered call. If the stock rises above the strike price of the option, the option will be exercised, forcing you to sell the shares for less than their full value, or buy back the option at a loss to avoid such a sale.

  • This strategy is often promoted in ways that make it seem like a sure winner, but in reality it’s an almost certain loser. You give up the opportunity for handsome profits when the stock price rises rapidly while retaining the risk that you’ll suffer a painful loss from a sharp drop in the stock value. Meanwhile you’re eaten alive by transaction costs, including hidden ones such as the spread between bid and ask on option prices.

The case

In this recent case, the taxpayer pursued the covered call strategy for stocks purchased at 100% margin (making a bad strategy even worse). In other words, for every $1,000 of his own money he invested in the stock he bought another $1,000 worth using money borrowed from the broker. As a result of this approach, he incurred hundreds of thousands of dollars in interest expense. If he filed as an investor, the bulk of this interest expense would have been nondeductible because of the investment interest expense limitation. The taxpayer filed instead as a trader, treating the margin interest as a business expense — and using the resulting loss to eliminate tax on hundreds of thousands of dollars of income from other sources.

The court found multiple reasons to deny trader status. The taxpayer didn’t trade with the kind of frequency and regularity expected of a trader. His holding period for stocks was long enough to indicate he was not seeking to capture daily or short-term swings in stock prices. In short, this case is typical of those in which a taxpayer claims to be a trader without having a plausible basis for asserting that status.

The interesting twist in this case is the use of the covered call strategy. The opinion says the taxpayer explained his strategy as one in which he hoped the stock would not be called away. In other words, he wanted to be able to retain both the stock and the option premium. That means he was hoping there would not be a short-term upswing in the stock price. He was also hoping not to see a short-term downswing in the stock price, as this would produce a loss that would at least partially offset, and potentially exceed, the option premium. Although the court didn’t make this point, you might say that someone pursuing this strategy is by definition not a trader. If a trader is someone who seeks to profit from short-term swings in the prices of securities, a covered call writer is the opposite: someone who seeks to profit from stability in stock prices. If that’s an accurate way of looking at the issue, then this taxpayer’s claim to trader status was doomed from the outset.

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