Tom Discusses Covered Calls, Stop Losses, and Strategies for Managing Stock Portfolio
Transcript:
Easan Arulanantham:
So our next question is on, I have a large stock position with some massive capital gains, you know, how do I manage this in my retirement portfolio?
Tom Vaughan:
Yeah. Okay. So, you know, we’re in Silicon Valley. So one of the things we’ve seen is large stock positions with large capital gains, you know, either somebody that worked at the company, you know, and accumulated stock through stock option purchase program, or what have you are issues, or they, you know, just new people, I mean, for example, for me, my sister was graduating from college, she had two job offers, one for HP, and one for this little company called Cisco had about 250 people in it at the time. And she asked me, you know, with my background to do some research on the companies, you know, what was the viability? And how did the stock look and those types of things. And so I looked into Cisco. Yeah. And I was really impressed with what they were doing. And they were growing like wildfire. And I actually going to recommended that she go there, and she did end up going there. And I bought some and that part of the proceeds to pay for my house came from the from that Cisco stock purchase. And so we’ve seen this a lot in our area. So I actually do have some strategy. Let me share a screen here, it’ll share, you know, let’s look at like apple, for example, here.
Yeah, here we go. Okay, so here’s, here’s the stock I run into all the time, you know, fantastic run, this is a daily chart for five years, right. So you can see what it did. I mean, really amazing, kind of been running sideways since last September here, but great, great run. And so I have a couple of strategies here. Number one, I’m not a really big fan of like selling a bunch of it to diversify, just because I have seen the wealth creation that these pieces can do. And now a lot of advisors are right around, say selling it. But there’s also a conflict of interest, they want you to sell it, so they can move it into something that they make money on. So I’d be very careful with that. What I try to take a look at is like, Hey, this is like a fruit tree. Right. So this is a tree that can produce for you. If you treat it right and handle a ride, it can, it can continue to do that. And once you do want to do those, maybe pick some of the fruit off and harvest some of that fruit really every year. And so a couple of strategies. But first and foremost, when I’m dealing with a client like this, I need them to understand that even though Apple is fantastic, it just had a 54% increase in revenue, it is one of the greatest companies on the planet, it doesn’t mean that it will always be the greatest company on the planet. So let me give you an example here, let me pull up GE I’ve had a lot of GE clients over the year, because they had a presence here, you know, the plant where, you know, near by where I live here and Willow Glen is was a GE plant. So this is GE over the last five years. And you can see it’s actually had a little bit of a run here. But you know, the high was 33 and the lowest $5. This one of the greatest companies on Earth, one of the first DOW components going back to the 1880s. And if GE can fall apart and have that type of a downturn, so can apple. So basically, that’s, that’s something I need people to understand right away, if possible, is just understand that
Apple could fall apart. And it is possible, and you probably don’t want to ride that all the way down, especially in your retirement and what have you. So I’ve got Apple back up here, let me zoom in just pick a one year period. And I’ll show you one of the strategies. So one of the things that I would think about doing here is really just kind of selling small parts, you know, harvest this fruit off of this tree, we’re going to keep this tree, keep letting it do that. And it depends on how much this is what’s the total value, how much is it of your total net worth, but you know, maybe you’re selling 1% of it a year, or 5% or 10% kind of depends on your situation, your outlook. But the way to do this, in my opinion is we do what’s called a covered call. And so a cover call is a really fascinating concept. Basically, you go out and you sell a call, which means that you get money. So let’s just say for example, I sell a call here at Apple and I get $1,000. So I get to keep that. And I have to pay taxes on it, which we’ll talk about but but I get $1,000. Now, I might buy one every 30 days. And let’s just say that I sell a cover call at $140. I’ll put an alert in here so you can kind of see, you know what I’m talking about?
Easan Arulanantham:
Let me quickly stop you right there. What’s a covered call?
Tom Vaughan:
You know, can you explain how that works? Yeah, it is the is what you’re doing is selling the right to somebody else to buy your shares at a certain price. And so let’s just say this is around $140. Right. Apple right now is at 127. You can see it’s flashing and so what I’m saying to that Person essentially is I’m going to let you have, let’s say 100 chairs or 1000, Chair, you know, whatever it is at $140. And so if Apple climbs in this 30 day period, for example, before this covered call expires, they’re going to what’s called call it away. So I get $140 a share, plus, I get, let’s say that $1,000, or whatever it might be, from selling the call, and I’m okay, because I’m trying to prune, you know, or harvest some of the fruit off of this tree, I just got $140, when it was worth 127, right. And if it doesn’t get to 140, I just get the $1,000. And I can go do it again the next month. And so I can keep doing covered calls, covered calls, covered calls. And if it never gets to 140, I’m just collecting income off of that piece. Now, this is just a small piece, right of the total, I’m not trying to sell the whole thing, I’m just trying to gather some fruit off in this tree. And so that’s a cover call is just a way for you to generate income. But really, what it does for me is it sets a price above where you are right now where you’re going to sell it. And so you know, with the client, I kind of determine, hey, you know, when it gets to 140, let’s, you know, sell a little bit of it. And instead of just putting in an order to do it, I’m going to keep selling these covered calls, so I can make money while I’m waiting for it to get there. And if it doesn’t get there, I just keep making money as far as that goes. So I do like cover calls.
The one risk to a cover call is if What if you know, during that one month, Apple goes crazy, and it goes to 160, you’re stilling to get 140 out of that sale. So that’s, that’s a disadvantage. But if I had a sale order in at 140, I’m only going to get 140. Anyway, so you know that and I’m only selling a small portion. So the other thing I would do, though, just in case is I would have that same number of shares, where I put in a stop loss, and the stop loss is designed to sell at some price. And so let’s just say, you know, looking at this chart right here, I might put a stop loss right down here. And again, you know, this is a bit more complicated than it looks. So I want at or below. And now I’ve got kind of this bottom piece here. So because I don’t want this thing to go, you know, falling apart, I want to harvest that fruit someplace in this range, if it goes above 140, good, we’ll take it, if it goes below, it looks like 121 15 here, give or take, Okay, good, we’ll take that too, you know, because we don’t want to get too greedy, we don’t want that to turn into 90 or, you know, things can happen.
And so anyway, that’s a way you know, on a very occasional basis, you know, once a year, twice a year, three times a year, where you can kind of harvest some of the fruit and generate a little bit of income, you know, during the period of time that you know, that you’re waiting for that price to happen that you’re interested in selling at. So now you got to pay up your capital gain on that. But, you know, I had, I had some clients that rode that gap all the way to the bottom, and they ended up with losses. So you just got to be careful. One of the things that does happen is people fall in love with their stocks, for obvious reasons, you know, you put in a small amount, and it turns into a large amount you love that. But you just got to be a little careful mentally not to get too attached. Because it can really impact your retirement, especially if it’s a big, big piece of your retirement. So that’s so that’s how I would handle it.
Easan Arulanantham:
So how powers like the income bro cover recall taxed compared to like a selling the shares?
Tom Vaughan:
Yeah, okay. So if you sell the shares, and you’ve owned them for more than a year, even if they’re called away by the covered calls, that’s going to be a long term capital gain, which has a maximum tax of 20%. If you sell a call, so each month that you’re selling a call, you’re getting some money, and it’s different amount, depending on how close you are to the price and what stock it is. But that’s going to be taxed as just ordinary income. So if you got $1,000 you just add it to your other ordinary income and that’s just part of your, you know, your taxes. So, you’re going to lose some of it to tax but, you know, I mean, you never were going to get that $1,000 before so it’s sort of found money. I mean, even if you get to keep you know, 700 debit or something. That’s still a pretty good deal.