Covered Call Lawyer: Options Strategy Losses on Concentrated Stock

What Is a Covered Call?

A covered call is an options trade on stock you already own. You sell someone else the right to buy your shares at a set price, called the strike price, by a set date. In return, you collect a payment, called the premium.

The trade-off is simple to state and easy to underestimate. You keep the premium, but you give up the stock's gains above the strike price. If the stock rises past the strike, you can let your shares go at the strike price, or buy the call back, often at a loss, to keep them.

Covered calls are not the only strategy sold this way:

• Collars. You buy a put to limit losses and sell a call to pay for it. You are protected below one price and capped above another.

• Options overlay programs. A firm or outside manager writes calls, or calls and puts, on your holdings on an ongoing basis, often inside a fee-based advisory account.

• Selling puts for income. Selling puts obligates you to buy stock if the price falls, which can add to a position you are already too concentrated in.

Who Gets Hurt: Retirees With Low-Basis, Concentrated Stock

These strategies are often pitched to people who hold a large amount of a single stock: a former employer's shares, an inheritance, or a technology stock bought long ago that has grown into most of their net worth. Many of these investors bought the stock for very little, so selling it would trigger a large capital gains tax.

That is exactly the investor for whom a covered call can backfire. A low-basis holder often wants above all to keep the shares, and a covered call is built to give them up when the stock does well. For an older investor, there is often another reason to hold: under current tax law, heirs generally receive a "stepped-up" basis on inherited stock, so a forced sale during life can cost the family far more than the premiums ever paid.

The Hidden Cost: Rolled Calls, Called-Away Shares and Tax Bills

When a stock rises toward the strike price, a financial advisor can "roll" the call, buying back the current call, often at a loss, and selling a new one with a later date or higher strike. Rolling can delay losing the shares, but it can also:

• Lock in repeated losses on the calls you buy back, while the cost of getting out keeps growing.

• Generate commissions on every trade, or justify an advisory fee, whether or not the strategy is working for you.

• End the same way anyway. If the stock keeps rising, the shares may still be called away, at a price far below where the stock is trading.

When shares are called away, the sale is generally a taxable event. For low-basis stock, that can mean a large capital gains bill in a single year, on top of the gains you gave up. Some options strategies, including certain collars and covered calls, can also raise complicated tax issues under the rules for straddles and constructive sales. A strategy that ignores your tax picture may not be in your best interest.

A Recent Example

A recent lawsuit filed in California alleges that a financial advisor at a large brokerage firm put a retiree in his seventies into a covered call strategy as "protection" for long-held technology stock. According to the allegations, the options were rolled through more than 200 transactions over four years, even after the retiree asked in writing to get out, while the cost of exiting kept growing. In the end, the suit alleges, his shares were called away at prices far below market value, followed by a large tax bill. The allegations have not been proven, but they show how these strategies can go wrong.

Which Rules Apply?

Reg BI. Under the Securities and Exchange Commission's ("SEC's") Regulation Best Interest ("Reg BI"), a brokerage firm and its financial advisors must act in your best interest when they recommend an investment, and may not put their own interests ahead of yours. Reg BI covers recommended investment strategies, not just single trades, so an options strategy recommended for your account must be in your best interest. That includes understanding the strategy's risks, rewards and costs, and having a reasonable basis to believe it is in your best interest given your age, goals, finances, tax situation and risk tolerance. The SEC has made clear that cost must always be considered, and that a firm generally should consider reasonably available alternatives.

FINRA's options rule. FINRA Rule 2360 adds options-specific protections. Before a firm accepts an options order, it must give you the options disclosure document and approve your account for options trading. In approving the account, the firm must use due diligence to learn the essential facts about you, including your investment objectives, age, income, net worth, liquid net worth and options experience. A qualified principal must then approve or disapprove the account in writing. The rule's suitability provision, Rule 2360(b)(19), also requires a reasonable basis to believe you can evaluate the risks of a recommended options trade and bear them financially. Firms must have supervisory systems that address their options business.

Fiduciary duty in advisory accounts. Many options overlay programs are run in fee-based advisory accounts. A registered investment adviser ("RIA") owes its clients a fiduciary duty under federal law. In a 2019 interpretation, the SEC described that duty as including a duty of care and a duty of loyalty: advice in the client's best interest, and full and fair disclosure of conflicts. See breach of fiduciary duty.

Common Claims in Covered Call and Options Cases

• Reg BI violations: a strategy that was not in your best interest given your age, goals, tax position, wish to keep your shares, or its cost compared with reasonably available alternatives.

• Misrepresentation and omission: a covered call described as "protection," "safe income" or "conservative," without a clear explanation that it can cost you your shares. See fraud and misrepresentation.

• Excessive trading: repeated rolls that produced commissions or fees out of line with any benefit to you.

• Ignoring your instructions: continuing the strategy after you asked to stop.

• Failure to supervise: options approval forms with inflated experience or objectives, or a firm that did not review an account with constant rolling and growing buy-back losses.

• Breach of fiduciary duty: an adviser that ran an options overlay without regard to your taxes, your goals or your instructions.

When many investors were put in the same options program by the same financial advisor or firm, see group cases.

Warning Signs in Your Account

• Your statements show the same calls being bought back and sold again, month after month.

• The cost to buy back your calls keeps growing as the stock rises.

• Your shares were called away, and you received a large tax bill.

• Your options approval form lists experience, income or objectives that are not yours.

• You told your financial advisor you did not understand the strategy, or asked to stop, and it continued.

• You are retired, and most of your savings is in one stock. See poor retirement advice and senior fraud and elder abuse.

How Brokerage Firms Defend These Cases

Daren spent years on the defense side, so he knows the playbook:

• "You signed the options agreement." An options approval form does not make every strategy in your best interest, especially if the form overstated your experience or objectives.

• "Covered calls are conservative." A covered call can reduce some risks, but it is built to give up your shares when the stock rises. Whether it fit your goals is the question.

• "The stock went up, so you made money." Giving up shares far below market value, paying for repeated rolls and owing a large tax bill can be a real loss compared with simply holding.

Documents That Help

• Your options account application, options agreement and any approval letters

• Account statements and trade confirmations showing each call sold, bought back or assigned

• Any advisory agreement or overlay program description

• Tax forms showing gains from called-away shares

• Emails, texts and your notes of calls with your financial advisor, especially any request to stop

Deadlines

Under FINRA Rule 12206, a claim cannot be brought in FINRA arbitration once six years have passed since the event that gave rise to it. Other legal deadlines can be much shorter. If you suspect a problem, talk to a lawyer promptly.

Why Investors Choose Daren A. Luma

Daren has 26 years of extensive experience in litigation, arbitration and regulatory matters involving the financial industry. He worked for 10 years at one of the largest defense law firms in the world, representing financial firms in litigation, arbitration and regulatory matters, and before that served as in-house counsel at one of the largest brokerage firms. He has seen how brokerage firms review customer complaints and build their defenses, and he now uses that experience for investors. Since founding the firm in 2018, he has represented over 400 clients and recovered over $130mm for investment victims. Prior results do not guarantee a similar outcome. He personally handles each case from start to finish.

• Strong Reputation — Over 26 years of practice specialized in the financial industry. I’ve achieved successful results in a wide variety of legal forums. Since 2018, I have represented over 400 investment victims and successfully recovered over $130 million for them.

• Individualized Attention — At my firm, unlike some securities litigation firms, you can trust that your case will be handled from start to finish by me instead of being handed off to a lower-level associate without the requisite knowledge or experience.

• Strategic Counsel — With experience as in-house counsel within a large brokerage firm and 10 years with one of the largest (defense) law firms in the world, I offer clients a well-rounded perspective on their investment loss issue. From there, my firm develops a comprehensive plan to achieve the best possible outcome.

Fees

Your first consultation is free and carries no obligation. Investor cases are handled on a contingency fee basis, with no hourly fees, and the firm is paid only if you recover.* How case costs and expenses are handled depends on the case and the client, and is discussed at your free consultation. In FINRA arbitration, each side generally pays its own lawyer and an award of attorney's fees is not automatic, which makes choosing the right lawyer even more important.

More on Complex Products and Senior Investors

Options strategies are one of several complex products we handle. See complex investment products for structured notes, annuities, leveraged exchange-traded funds ("ETFs") and more, and senior fraud and elder abuse if the strategy was sold to an older investor. You can also read Leveraged ETFs: Danger Hidden in Plain Sight.

Frequently Asked Questions

My stock went up. How can I have lost money?

If your shares were called away, you gave up the gain above the strike price, and you may have paid to buy back calls along the way and owed tax on the sale. Compared with simply holding the stock, that can be a large loss.

I signed an options agreement. Can I still bring a claim?

Often, yes. The firm had its own duties to approve the account properly and to recommend only a strategy in your best interest. Signed forms are a common defense, but they are not always decisive, especially if the information on them was wrong.

My account was in a fee-based advisory program. Does that change anything?

It can change where and how the claim is brought. An RIA owes you a fiduciary duty, and disputes with an RIA generally go to arbitration under the advisory agreement or to court. Many accounts at large firms involve both a brokerage firm and an advisory program.

Lost Shares or Money in an Options Strategy?

If a financial advisor put you in covered calls, collars or another options strategy that was not in your best interest, talk to Daren before a deadline passes. Call (914) 304-4051 or request a free consultation. The consultation is free, and investor cases are handled on a contingency fee basis, with no hourly fees: the firm is paid only if you recover.*

*Investor cases are handled on a contingency fee basis, with no hourly fees. How case costs and expenses are handled depends on the case and the client, and is discussed at your free consultation.

Attorney Advertising. Prior results do not guarantee a similar outcome. This page provides general information, not legal advice, and contacting the firm does not create an attorney-client relationship. Responsible attorney: Daren A. Luma, Daren A. Luma, PLLC, 75 South Broadway, Suite 400, White Plains, NY 10601, (914) 304-4051.

Stock ticker photo: Jaclyn Nash / Smithsonian National Museum of American History, public domain, via Wikimedia Commons. Covered call payoff diagram: Daren A. Luma, PLLC (original).