Act 60-Covered Calls
CREATING CAPITAL GAINS
Many U.S. residents have discovered the financial benefits of relocating to and establishing a legal domicile in Puerto Rico since the passage of Acts 20/22, now codified as Act 601. One becomes a bona fide resident of Puerto Rico by meeting a physical presence test, a tax home test, and a closer connection test (https://tomduffycpa.com/wp-content/uploads/2019/09/Bona-Fide-Residency-in-Puerto-Rico.pdf). There are numerous advantages on both the personal and corporate side, but this article will focus on potential strategies for one’s personal investing.
An Act 60 investor will owe a U.S. Federal tax bill2 on most interest and dividends not sourced to Puerto Rico. For example, a bona fide resident of Puerto Rico owns a U.S. stock which pays a dividend of 2%. The dividend would be taxed at the investor’s U.S Federal ordinary income rate. Thus, an Act 60 investor could seek to focus on capital gains to maximize the benefits of the decrees. The use of call options is one way to create capital gains, and can be done consistently through the year.
A call is an options contract that can obligate the call seller to sell shares at an agreed upon strike price. If the stock price increases beyond the strike price, they will be obligated to sell the shares at the strike price, gaining from the original entry price for the stock up to the strike price, but missing any additional appreciation of the shares above the strike price. A call buyer has a right, but not an obligation, to purchase the security. A call is considered covered when the investor owns the underlying security in an equivalent amount to the option contract. A short call is when the investor sells a call option without owning the underlying security.
A specific strategy to generate capital gains involves selling call options. Call options can be sold against individual stocks, ETFs or an index such as the S&P500. Call options sold against individual stocks are typically sold with an expiry 60-90 days away, which will generate short term capital gains, per IRS Publication 550.
COVERED CALL WRITING
A covered call is an agreement to sell a stock when it reaches a certain price, called the strike price, within a certain time period, called an expiration date. For agreeing to sell a stock at the agreed upon price, the seller is paid an up-front premium known as a call premium3. There are three outcomes a call seller could experience:
- The stock never reaches the strike price within the stated time period and is never assigned (or, in other words, the investor is not required to sell). The seller keeps the stock and the premium.
- The stock reaches the strike price at the expiration date, or possibly sooner. In this case, the call likely will be assigned, requiring the investor to sell the stock at the specified price. The investor keeps the appreciation from the higher stock price as well as the premium, as additional income, but must relinquish the stock.
- The price of the stock falls. In this case, the investor keeps the stock and the premium. Please note, equity options are American style, which means the stock can still be assigned anytime even if the call is out of the money, but one would be able to buy the shares on the open market for cheaper than one is selling them.
Illustrative Example:
John is an Act 60 investor and purchased 100 shares of XYZ Stock and it is currently trading at $100.00 per share. John sells a call option, for $5 in premium, on XYZ at a strike price $125.00 with an expiry 60 days in the future. Using the above scenarios:
- John keeps 100 shares of XYZ and $5.00 in premium
- John sells 100 shares of XYZ for $125.00 per share. He forsakes any upside past the strike and ends up with 100 * $125.00=$12,500.00 and the $5.00 in premium
- John keeps 100 shares of XYZ and $5.00 in premium
Therefore due to his Act 60 benefits, John would not pay tax on the $5.00 in call premium and on the sale in Scenario #2.
FACTORS AFFECTING PREMIUMS
Many variables affect option prices. The volatility of the underlying asset is a key factor in calculating the option premium. Volatility is the measure of fluctuation, not direction, of stock-price movement. Since volatility reflects both upside and downside price potential, an increase in volatility typically will increase both call premiums. The underlying stock price may also have a major influence on the price of an option. Typically, as the underlying stock price increases, the value of calls also increases. As the stock price decreases, the opposite usually occurs. Other factors, such as interest rates, the dividend paid by the underlying stock and general market conditions, may also influence the price4.
SUMMARY
Covered call writing can be a particularly interesting strategy for Act 60 investors who would like to generate tax beneficial income. The strategy typically aims to produce continuous short term gains which accrue to the investor without tax. The major drawback is if the seller is forced to sell and thus misses any future appreciation.
IMPORTANT COVERED CALL DEFINITIONS
Call Purchaser - An option in which the holder (owner) has the right but not the obligation to buy the underlying stock at the strike price for a certain, fixed period of time (until its expiration).
Covered Write - A position in which a call option is written (sell) against a long stock position.
Assignment - Writers of American options can be assigned at any time. Upon assignment they receive cash from the option owner and must deliver the underlying securities.
American-style - An option that can be exercised/ assigned at any point before expiration. Equity options are American style.
Bid - The disseminated price at which exchanges indicate options can be sold.
Break Even Point - The initial stock price minus the premium received. Standstill Return = Option Premium Collected / Current Stock Price. If Assigned Return = ((Strike Price - Current Stock Price) + Option Premium Collected) / Current Stock Price.
Options Contract - One options contract typically represents 100 shares of stock. Premium - The price you pay if you’re an option buyer, or the amount you receive if you’re an option writer.
Strike - The price at which stock is traded upon exercise/ assignment of an option contract. Some options have multiple underlying stocks. In these cases, the strike times the multiplier is the total price paid for all of the options’ underlying securities.
Time Decay - The decline in value of your option as the expiration date approaches. Time Value - The perceived and often-changing value of the time left until an option’s expiration.
Underlying - The cash or securities that are delivered upon exercising an option. Most options deliver 100 shares of a single stock.
Writer - If you sell an option to open a new position, you’re a writer.
ABOUT THE AUTHOR
Trevor Ronderos is a Director at Alex. Brown, a division of Raymond James and based in Miami, FL. His practice is focused on providing wealth management solutions to Puerto Rico based investors. He was previously a Vice President at Goldman Sachs & Co, and has almost nine years experience of assisting Puerto Rican clients. Trevor received an MBA from the University of Michigan-Ross School of Business, and as part of his studies completed a project for the Puerto Rico Departamento de Desarrollo Economico y Comerico (DDEC) on the feasibility and economic impact of Acts 20/22.
He can be reached for comment or question at trevor.ronderos@alexbrown.com.
1 https://taxsummaries.pwc.com/puerto-rico/individual/other-tax-credits-and-incentives
2 https://www.law.cornell.edu/uscode/text/26/933
3 https://rjnet.rjf.com/quilt/api/document/0449828e-b83f-4d16-96fb-7ea3f92cc934/1
4 https://rjnet.rjf.com/quilt/api/document/928ef388-8d23-4b44-b459-a60b566030c1/3
Raymond James & Associates, Inc., Member New York Stock Exchange/SIPC.
Options involve risk and are not suitable for all investors. When appropriate, options should comprise a modest portion of an investor’s portfolio. Prior to buying or selling an option, a person must receive a copy of “Characteristics and Risks of Standardized Options” (ODD). Copies of the ODD are available from https://www. theocc.com/about/publications/character-risks.jsp or by contacting Raymond James at 880 Carillon Parkway, St. Petersburg, FL 33716.
The information in this document is provided solely for general education and information purposes and, therefore, should not be considered a complete description of listed options. No statement within this document should be construed as a recommendation to buy or sell a security or to provide investment advice. Please consult a tax advisor for the tax implications.
Investing involves risk and you may incur a profit or loss regardless of strategy selected. Options involve unique risks, tax consequences and commission charges and are not suitable for all investors. When appropriate, options should comprise a modest portion of an investor's portfolio. No statement within this document should be construed as a recommendation to buy or sell a security or to provide investment advice. Prior to making any options transactions, investors must receive a copy of the Options Disclosure Document which may be obtained from your financial advisor, from cboedirect.com/Resources/Intro.aspx or by contacting Raymond James at 880 Carillon Parkway, St. Petersburg, FL 33716. Supporting documentation for any claims (including any claims made on behalf of options programs or the options expertise of sales persons), comparison, recommendations, statistics, or other technical data, will be supplied upon request.
Raymond James and its advisors do not offer tax or legal advice. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
