For most people who trade options, the strategy of choice is covered call writing. And investors who employ this strategy do so for many reasons: it reduces downside risk, enhances the income stream and takes advantage of the favourable tax treatment associated with option premiums.

But with the Chicago Board Options Exchange volatility index — the VIX — nearing historical lows, it is harder to find an attractive covered call write than it is to find the Loch Ness monster.

What constitutes an attractive covered call write? Professional options trader Lawrence McMillan, president of Morristown, N.J.-based McMillan Analysis Corp. (www.optionstrategist.com), maintains a set of parameters in order to determine whether an option is an attractive covered call write. The option must:

> be a quality stock (U.S. stocks in the Standard & Poor’s 500 composite index or Canadian stocks in the S&P/TSX 60 index);

> have expected returns of at least 12% cash or 20% margin; and

> be a stock that has a respectable chart pattern (a stock that is not in a downward trend).

One approach covered writers seem to be employing, despite current premium levels, is a strategy known as “overwriting.” In this strategy, you sell “out of the money” calls against a portfolio of stocks that have been held for long periods.

The typical person engaging in this strategy is someone who has a fairly large holding of individual stocks. Presumably, the investor wants to keep the shares because he or she either likes the company or has a low cost base. In terms of the low cost base, the trick is to avoid the tax consequences of an assignment notice.

But, unfortunately, when you sell a covered call, there is always the risk of an assignment, no matter how far out of the money the strike price is. And even though there are follow-up strategies to minimize the tax consequences as much as possible, they cannot be entirely eliminated.

In that sense, the overwriter differs from the typical covered call writer, the latter of which generally sets the strike price at a level at which he or she presumably would be willing to sell the shares.

In contrast, the overwriter wants to keep his or her shares, while continuing to sell out-of-the-money calls for income. So the obvious questions are: is this possible; how can it be done; and what are the pros and cons of doing so?

Let’s assume that you hold 1,000 Royal Bank of Canada shares (symbol: RY; recent price: $90.81) with a cost base of $50 a share. When the stock was at $80 a share, you sold 10 January 85 call options that, at the time, did not look as if they were likely to be assigned. But at the end of 2005 — and with Royal Bank at $90.81 a share — your short call is almost $6 “in the money” and it is guaranteed to be assigned in January. But concern about selling stock with a $50 cost base in January makes the taxman the focus of Christmas rather than Santa Claus.

Given that scenario, action has to be taken before the options expire and the shares are called away.

One approach is simply to buy back the 10 contracts that were fully covered by the Royal Bank shares.

But what if, given all the spending you have done during the Christmas season, you simply do not have enough cash in your account to buy back the options at a loss?

One way to generate the capital to cover the short calls is to sell a small portion of the stock. For example, if a debit of $6,000 were needed to buy back the 10 calls at a price of $6 a share, you could sell 66 shares of Royal Bank stock to net slightly less than $6,000. By doing this, you not only get to keep the gains on the majority of shares (1,000 shares less 66 shares = 934 shares remaining), but you are also free and clear from the pending liability of delivering the stock against the call.

Moreover, because a substantial number of shares are still held after the smoke clears, a new call option can be sold to continue the income production.

@page_break@The tax strategy of all of this is that the capital loss that is incurred from covering (buying back) the short calls offsets some of the gains taken on the 66 Royal Bank shares that are sold.

In short, the overwriter has avoided substantial tax consequences, maintained the bulk of the stock holdings, participated in upside appreciation and now has the opportunity to sell more call options on the remaining 934 shares.

McMillan has managed such accounts since January 2001. In those five years, slightly more than 4% of the shares have been called away but more than 45% have collected option premiums while maintaining the stock position.

But keep in mind that 2001 and 2002 were severe bear markets and option premiums were inflated. In many cases, those expensive premiums totally offset the losses in the underlying stocks in that bear market, McMillan says.

As of September 2005, the overwriting accounts have grown by 21.6%, while the same stock portfolios that are unprotected by option credits would still be down 24%. IE