A former classmate of mine from my undergraduate days (he and I were officers for the Finance Club once upon a time) sent me a question about option trading.
I want to get your thoughts on something – A covered call option that I wrote is now at the money with expiration in Jan. I planned to sell it in the new year so this is fine. Logically, it shouldn’t be exercised early but I’m not sure it will hold in practice? So, if the option is exercised early will I have a chance to settle for cash? or buy an offsetting option or the shares? It’s a big gain and selling the shares now means a big tax bill in 2010, that I’d prefer to hold off another year.
Now, I’m sure our derivatives professor will be disappointed that he doesn’t remember all the stuff he learned, but that was nearly 20 years ago, so I think some slack can be cut at this point. 
Just for quick clarification for those not in the know, a covered call strategy is one in which a person holding stock (or futures, etc.) writes/sells a call option against their position. It’s a type of yield enhancement strategy in that selling the option provides a bit of income. Of course there are limitations and caveats. I won’t go too far into them here, though.
The concern of my classmate is about the stock being called from him prior to year-end. The option strike is clearly above his purchase price, meaning were he forced to sell it to the holder of the option he would have a gain to be booked, and thus a tax liability. He’d rather avoid that happening until into 2010.
Now options are very rarely excercised early because it generally doesn’t make sense to do so. The only time early exercise pays off is if there is no time value left on the option, implying the option is trading at or below intrinsic value. That basically never happens.
Of course you cannot be 100% sure an option won’t be exercised, which is my classmate’s concern. The problem, however, is that you can’t cancel out exercise risk all together without buying back that option. He could reduce the prospects for an unwanted exercise by rolling to a further out option and/or to a further out of the money strike, but any alternate strategy would still require buying back the original option in order for the exercise risk to be reduced.
But this does bring up an important point. As traders we often don’t give a lot of thought to the tax consquences of what we do, focusing instead mainly on attempting to generate profits (can’t tax what you don’t make). Sometimes, though, it makes sense to take a look at the tax implications of things.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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