Back in March, it looked as if 2009 would be at least as painful for stock investors as 2008 was. Yet the nearly unprecedented rally that ensued not only made up for those early losses but also went a long way toward earning back much of the money investors lost during the previous year's bear market.
The speed of the stock market's recovery, however, may have you nervous about whether those gains can last. If you find yourself wanting to lock in your profits, the easiest thing to do is just sell your stocks. But if you do that today -- just before the year ends -- it could create a big tax problem that you'll have to deal with in the coming months.
A better option
There's a better strategy, though, if you're open to the idea of using options. In particular, a variation of the popular covered call strategy can help you preserve your gains without immediately creating a taxable event.
A covered call involves writing a call option on a stock that you already own. In exchange for a premium, you agree to sell your shares at a specified price -- known as the strike price -- during a certain time period. If the stock is above that price when the option expires, then the buyer of your option will exercise it, and you'll have to sell your shares.
Usually, people who use covered calls are inclined to keep their shares, and so they choose a strike price that's higher than the current stock price. But if you actually want to sell the shares, then adjusting your strike price downward can help you lock in some profits while also giving you some extra money for your trouble.
Locking it in
As an example, let's say you were smart or lucky enough to buy shares of Google
If you want to call it a day and reap your profits, you could simply sell the shares and earn a $311.68 profit. But let's look at what happens if you use a covered call strategy.
One alternative to selling would be writing a call letting someone buy your shares from you for $550 anytime between now and mid-January. Based on recent prices, you'd get paid about $63.45 per share for writing the call. If the stock remains above $550 during the next three weeks, then you'll end up selling your shares and get total proceeds of $613.45.
Now granted, you're only earning an extra $1.77 a share for your trouble, which might not seem worth it. But different options offer better payoffs. Look at these examples:
|
Stock |
Recent Stock Price |
Call Option |
Option Price |
Increase in Proceeds
|
|---|---|---|---|---|
|
Wells Fargo |
26.85 |
April $25 |
3.30 |
5.4% |
|
Wal-Mart |
53.32 |
January $52.50 |
1.32 |
0.9% |
|
Las Vegas Sands |
15.60 |
March $13 |
3.57 |
6.2% |
|
IBM |
130.00 |
April $125 |
8.52 |
2.7% |
|
Chevron |
77.04 |
June $70 |
9.30 |
2.9% |
|
PotashCorp |
111.44 |
March $100 |
15.85 |
4.0% |
Source: Yahoo! Finance as of Dec. 23 close.
More importantly, you're not treated as selling the shares until the option gets exercised. That means you get any dividends that your stock pays.
The real payoff, though, is that you don't have to pay immediate tax on your capital gains. If your option doesn't get exercised until January, then you won't include the sale of shares on this year's tax return. In effect, you can push back your tax bill an entire year.
There's always a trade-off
The covered call strategy is a bit riskier than simply selling the shares, however. If the stock price drops below the strike price of the option you wrote, then your buyer won't exercise the option, and you'll own shares that are worth a lot less than they were. However, you get to keep everything you were paid to write the call, which will often make up for much of the losses. And if you like to hunt for bargains, it's entirely possible that you would have bought back the shares after a big correction anyway.
Also, you can't use the strategy to try to turn short-term gains into long-term ones. Writing a call option whose strike price is less than the current share price either suspends or resets your holding period on the stock you own.
Of course, those who invest for the long run don't worry much about grabbing short-term profits. But for those who want to lock in gains quickly, covered calls can be a great alternative to the big hit that comes from selling shares.
Want to know more about options? Check out this introduction to the subject, which will show you all the resources the Fool has to offer on useful investing strategies.
