• 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?
 

In my portfolio watch list, only a handful of stocks are good to buy in this overvalued market. The list is not yet complete, but I have time to fill in other stocks later on.

Most of the stocks are dividend aristocrats. Some lost the status many years ago yet I decided to keep them, others lost the status this year due to COVID, and I decided to keep them too as I still think they are good companies, e.g. Disney (DIS) and the dividend cut or suspension is temporary.
 

Account Net-Liq: $7,477.66
SPX value: 3,426.96
Shiller PE: 31.47
 

In my older post I wrote about the market high valuations and how you can mitigate the problem with valuation.

You hear (and read) people complaining that valuations are high and there is nothing to invest in. It is not true. And people who say that do not do their homework properly.

I must admit, that when I was writing my original post, I too made the same mistake and looked at stocks via whole market magnifying glass and ignored the reality, that the whole market doesn’t represent the stocks. It is the stocks that represent the market. Unfortunately, SPX or SPY represents only a fraction of the market and it can be easily manipulated by a few stocks. Before you start complaining about it, let me assure you, it has been like that since the inception of the aforementioned indexes. They were set up that way from the beginning and there will always be stocks that have significant weight to push SPX higher although the entire market is different.

It was the case with the recent rally. The SPX was rallying hard and many could get the impression that all stocks became expensive. Nope, it was only a few tech stocks that moved the market, others lagged.

I could see this phenomenon in my portfolio. While SPX was making new all-time highs, my portfolio net-liq was going down. It was best illustrated when you looked at the heat map back then.

This is how the S&P500 heat map looked like:
 

It is obvious what was driving the market up. Technology stocks, communications… everything else was red. It is something you would expect. People are sitting at home, doing nothing, some trading stocks at Robinhood and losing money, others using computers, like kids in schools, shopping, watching TV shows, or zoom, go-to-meeting app, or other apps to do their job (those lucky enough to have a job). Other businesses struggle.

This is how IWM, representing small caps looked like:
 

I am pointing this up to show that although the market, represented by SPX, was making new highs, not all stocks participated in this rally. And even if they did, they were still undervalued by their earnings and P/E measures.

If people really keep screaming about the market being overvalued, then they do not really look under the surface. And I must admit, I fell for this too and dismissed the entire market as overvalued meaning all stocks were overvalued.

But, they were not.

In my previous post I published the following table indicating high quality dividend aristocrats with great dividend history and highest yield among the aristocrats.
 

And I was eager to start accumulating these shares as per my original plan and once I reached 100 shares, start selling covered calls. My only defense against high valuation was selling covered calls and puts around these positions and lower my cost basis.

However, I decided to take another look at valuations when I realized that not all stocks are overvalued. Some may be valued correctly, some still undervalued, and of course some grossly overvalued.

I took another look at my previous selection and decided to add a few comparisons. My criteria for valuation were:
 

• Current P/E
• Theoretical (calculated) multiple P/E value based on market historical valuations
• Calculated intrinsic value based on earnings growth and P/E multiple
• Income generated from dividends must beat income from S&P 500
• Stock growth must beat S&P 500 growth

Based on these criteria I reviewed my previous selection once again and the result was that only two companies were undervalued and beat the market:
 

From the new table, there are two patterns I am going to follow:
 

1. All three criteria must be met, that is, the stock must be undervalued, its income and growth must beat the market.
2. It is OK to have a stock that is undervalued and its income beats the market only.

Based on these results, I will be accumulating stocks that meet all three criteria (pattern #1), and eventually, once all stocks of my interest are all accumulated, I may start accumulating stocks that meet only two criteria (pattern #2). However, the valuation of any stock must be always “green” (undervalued) in order to keep buying these shares. If a stock is overvalued, I will skip purchasing and wait for a correction or pullback to start buying.

There are stocks, though, that will always trade at high valuation (premium) no matter what. For example, Realty Income (O) was always overvalued. I checked the 20-year history of this stock and it never traded at its earnings valuation. Only once in the 20-year period, the stock pulled back to its fair value – in 2008.

The same valuation issue is with Coca Cola (KO). The stock always traded at a premium to its fair value. Waiting for it to be fairly valued, you would never buy. It only happened once when the stock pulled back to its fair value – in 2008.

These are stocks I consider high-quality stocks and I like to own them. Buying them, though, I would have to bring their valuation artificially down – using options and selling puts and covered calls.