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Tax Rule Will Slash Covered Call Volumes

17 Dec 2004

The U.S. options market is bracing itself for a drop in the number of fund managers executing covered calls because of a change in the tax law.

The U.S. options market is bracing itself for a drop in the number of fund managers executing covered calls because of a change in the tax law.

Robert Willens, a tax and accounting analyst at Lehman Brothers, said investors selling in-the-money qualified covered calls can no longer receive a 15% dividend tax rate. He thinks volumes will drop next year and is telling derivatives professionals to expect the change. "They must be aware that it's not fund driven but tax driven," he said, adding the law's impact will be substantial.

The tax change came into force as part of the Jobs Creation Act, which was introduced in late October. Since the rule change, Willens has noticed both corporate and individual investors turning their interest to preferred stocks because of their relatively high dividend. "This is probably as good of an alternative as I can think of," he said, adding that investors he deals with have been eager to maximize their dividend income.

For yield investors, preferred stocks are the way to go, noted a new product developer at another major bank. But the yield on preferred margins will lower as more investors buy, he said. Investors who want to own stock and who are looking to pick up extra yield may opt to reformat their options, he said, writing them slightly out-of-the money for a lower premium. "There was no warning they were going to enact something like this," Willens added.

17 Dec 2004

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