• This post is about my view on selling covered calls below the cost basis of your stock (stock purchase price) when overwriting your portfolio.
• Is it a problem or a betterment to your portfolio?
• Other implications, such as taxes.

I have seen investors expressing their concerns when the markets dropped earlier this year and now when we are seeing another 10% (and maybe even more than that) correction. Many said, that they had to sell their covered calls below their purchase price and now they are worried that if a stock goes up, they may be assigned and realize a significant loss being forced selling their position below their cost basis.

I was afraid of this event too. But, I was thinking about this and realized, that being assigned, is not such a bad thing as you may think. Let’s review my thinking process and see what roadblocks are there when selling covered calls and you have to sell below your cost basis.
 

If you are like me and try to build and accumulate your portfolio, you may have been accumulating shares of your favorite stocks when the market was all booming, everybody was optimistic, FED was raising interest rates (well, maybe not yet), the economy was rosy, someone was boasting how great job he has done and multiplied your 401k, the future was brighter and brighter every day, and you kept buying and buying your dream shares.

Then, you have reached your goal and accumulated 100 shares of your favorite stock and started selling covered calls to boost your income, so you too could boast about your investing skills.

But then, all the bright future dimmed. Actually, the future just crashed, you got sick seeing your work disappear and now, you were thinking: “What now?”
 

I had the same experience. I accumulated 100 shares of AT&T (T) and my cost basis was $31.94 (I was lucky on this one as I have another great stock which I accumulated at a lot higher cost). Today, AT&T is trading at $28.63. Looking at the options chain, there is no premium at the cost basis or above. No matter which expiration you look at, there is no premium worth taking the risk of an assignment.
 

What to do?
 

You have two options:
 
1) Do nothing, stop selling covered calls until the stock price recovers at or above your cost basis, and then you can start selling covered calls again.
Or
2) Keep selling covered calls but below your cost basis to collect a decent premium. For example, selling a 60 DTE at 30 strike can bring you 0.37 cents or 37 dollars premium. It is OK. I can take it.
 

But wait a minute. If you sell at 30 strike with a 31.94 cost basis and get assigned, you will realize a $1.94 or $194 loss! The premium will lower the loss but not much. And I do not want the loss.
 

There are again a few options you have
 
1) Try to keep rolling your calls higher and away in time. I have done that on a few positions to avoid their assignment and give the stock time to recover.
2) Close the position before it gets in the money. The closing cost will be probably less than the full loss and that may be acceptable for you.
Or
3) Let it assigned.

Once you get assigned, I usually use the proceeds to sell in the money puts. For example, I got assigned and my shares were called away at 30 a share but I immediately sold 29 in the money puts and collected 1.11 credit. If the stock stays depressed, then I get assigned and buy my 100 shares back at 29 a share. If the stock starts moving higher, I start rolling my puts higher too, collecting more credit.
 

What have I just achieved here?
 

First, I have collected a $37 credit on the original covered call.
Second, I got assigned, sold my 100 shares and realized $194 loss on the stock.
Third, I sold new in the money put and collected $111 credit.
Fourth, I lowered my original $31.94 cost basis down to a new $29 a share cost basis.
Fith, I can now sell a new covered call with 30 dollars strike, collect additional 0.40 credit and have a potential gain of $100 on the stock if I get assigned again.
 

I see this as betterment for my portfolio. For a small cost, I could “roll” my stock down, improve my position, and gain potential. And the cost I paid (about 0.46 per contract or 100 shares) was quickly offset by the new covered call sale and added potential gain on the stock which would not be possible should my original cost basis stay.
 

What’s the catch here?
 

Honestly, I do not see many (though there are a few). I actually liked the result of improving my portfolio holdings. The only issue is that you may lose a dividend if this swap of cost basis happens around the ex-dividend day and you happen to be so unlucky that you miss the dividend. In this case, it is better to buy shares outright and not using puts to buy in.

The second issue could be a taxable event. If you were called away on your stock prior to the minimum tax holding period in order to treat your sale as a long term gain and not a short term one, you may be hit with a higher income tax. Also, if you sell the stock and buy back in the position within the 30 day period, this would be treated as a wash sale and you will not be able to use the tax loss to offset your tax gains. However, my trades are small at this time that I do not worry about these events yet.
 

What about you? Are you afraid selling covered calls below your cost basis?