In this article you will learn in detail about Stock Price Goes Up and Down. Like how stock price goes up and down? And what does it mean when a stock price goes down? You will learn many more important things.
How stock price goes up and down?
When more people demand the shares of the company, the share price goes up. Conversely, if more people want to sell a company’s stock than buy it, there will be more supply than demand, and the share price goes down.
Stock Price Goes Down:
What does it mean when a stock price goes down?
Let us consider a worst-case scenario: ABC Corp. stock declines from your purchase price of $35 (February 21) to $25 per share on May 20. (The very worst case would be if the company went broke and its stock fell to zero. Remember, diversify the portfolio to minimize the risk of a bankrupt stock.)
In this example, the tax consequences are not good. There is a realized capital gain of +$8.50 taxable as ordinary income. The unrealized capital loss in the stock of −$10 per share is a reduction in your equity. The only comfort is the pretax hedge given to you by your receipt of the cash option premium of +$8.50. This cash flow reduced your pretax loss in equity to −$1.50 when the stock value went down $10.
This stock is only one of some 20 stocks you should own in your option income portfolio. You would expect to have some short-term losses from other options that you sold and then bought back at higher prices. These net realized capital losses can be applied against the $8.50 net capital gain you received.
Do dividends go down when stock price goes down: Clearly, buying stock at $35 and selling options for $8.50 is a more conservative way to own stock than if you simply purchased stock and then waited for its market price to rise. On a pretax cash basis, your invested capital would not be reduced until the stock price declined from $35 (your cost basis) to $26.50, a 24-percent decline.
Stock Price Goes Up:
Despite how high the stock price may go, you agreed to sell your stock for $30. Actually, you are selling for the $30 strike price plus the $8.50 option premium.
Let’s consider the net effect of buying back the option offset when the stock price is above the strike price (when the option is trading in-themoney). When you buy the option offset, your obligation to sell stock at the exercise price has been canceled. Now you can use the new higher market value of your stock to sell a higher strike price option.
If the stock price on May 20 is 45, you will pay $15 for the option buyback (option offset). This produces a realized short-term capital loss of $6.50 ($15 − $8.50 = −$6.50). Your unrealized capital gain in your underlying stock becomes +$10 ($35 up to $45).
You have an unrealized gain of $10 in your portfolio equity and have a realized loss of $6.50. What you have done is shift assets from one position to another. You picked up a nontaxable equity gain and realized a tax loss benefit.
In rising markets, you will generate year-to-year tax loss carryovers, normally short-term. Any unused capital loss remaining after taking the maximum deduction allowable against ordinary income can be carried over indefinitely until used. Many investors build a loss carryover account, which allows them to realize tax-free cash in the future. Your trading gains realized on a future trade can be offset by losses in the loss carryover account.
This loss carryover account is valuable because it comes from your option buyback activities, which can produce nontaxable gains in your portfolio. You actually gain equity while receiving a short-term tax loss. You make money while generating a tax deduction.
Exercising an option may be to your advantage. If you wish to sell the underlying stock at expiration, you simply do nothing. When it is in the money, it will be called. This is a welcome exercise that you control. In fact, rather than just selling stock, I often will give it the last write (rite, as for the dead).
I sell an option deep in-the-money, knowing that it will be called. It usually does the trick. If the stock should drop below the strike price, after writing it deep in-the-money, you can keep a large premium and do it again. The welcome exercise is of greater value because of the favorable tax treatment of capital gains. Normally, cash option premiums are short-term gains.
When the underlying stock is called away, the option premium received assumes the status of the stock’s long- or short-term characteristic.
The adjusted sales basis of the stock called away is the strike price plus the call option premium. If the stock is a long-term holding, the option premium will be considered a long-term holding. This gives you the opportunity to turn a short-term capital gain (the option premium) into a long-term holding for tax purposes.
The unwelcome exercise happens suddenly. You receive an unplanned demand from the holder of the option to exercise his right to buy your stock at the agreed-upon strike price. You do not have any control of the unwelcome assignment. OCC procedures require that on the same day you are called or assigned, you must comply with the terms of the option contract. You must deliver the stock.
Please pay close attention! Notice I said you must comply with the option holder’s request and deliver stock. It does not have to be your shares . . . just the same number of shares for the same strike price. Yes, here is the time for fungible and fungibility. You can buy shares on the open market and deliver these if you want to or let them have your shares.
Whether the exercise against you is welcome or not, it is essential that you understand in responding to an exercise that you do not have to sell your originally optioned shares. Your choice is (1) to deliver shares you already own or (2) to buy and deliver new shares purchased on the open market at the prevailing price. Selling the new shares to the option holder at the strike price fulfills the terms of the contract, using fungibility.
It will be easier to understand if we go back to the last trades we did with ABC Corp. On February 21, we bought 100 shares of ABC Corp. at $35, and on the same day, we sold an option (ABC Corp. May 30 for $8.50). On May 20, the ABC Corp. stock is selling for $45, and your broker informs you that your 100 shares of ABC Corp. stock was exercised for $30.
The adjusted sales basis of the stock called away is the strike price plus the call option premium. If the stock is a long-term holding, the option premium will be considered a long term holding. This gives you the opportunity to turn a short-term capital gain (the option premium) into a long-term holding for tax purposes.
Your decision is to retain your shares. For whatever reason, you do not want to sell them. Maybe you want to hold them long enough to realize a long-term capital gain. Another consideration is that the stock has gone up from $35 to $45 a share and you would prefer to keep the lower-cost shares in your portfolio and avoid a taxable event if possible.
You bought the shares at $35. You wrote the call for $8.50. Now you have been assigned at $30. The tax implications: −$35 + $8.50 + $30=+$3.50 × 100 = $350.00 short-term taxable capital gain. Your decision is to buy new shares today at $45 and sell these for $30 in cash. You wrote the option for $8.50 to sell stock for $30 and buy stock todeliver at $45. The tax implications: + $8.50 + $30 – $45=−$6.50 × 100 = −$650 short-term capital loss.
|Cost basis of 100 ABC Corp @ $35||$3,500|
|Market value of 100 ABC Corp @ $45||$4,500|
|Gain in stock value||$1,000 (nontaxable)|
|Short-term capital loss||−650 (deductible)|
|Net after-tax gain||350|
You received a net nontaxable gain of $350, 10 percent in 90 days on your equity of $3,500. Plus . . . your tax savings are used at tax time. Your annualized, after-tax return on your applied equity is 40 percent. Note that the gain in equity resulted from the time value of the cash option premium at the time of your opening sell.
There has been no decrease in your equity by these trades, because you owned the underlying stock. Your after-tax equity increased. As part of the transactions, you obtained a realized short-term capital loss. These losses are not reductions in your equity. These losses from option buybacks may be accumulated during the tax year. If you do not use all the losses in one year, you may carry the unused losses to later tax years.
Such totaled option buyback losses become the source of the tax-loss carryover account discussed previously. We are realizing tax losses without equity losses. Under decision two, you bought 100 shares of ABC Corp. at $45, or $4,500 cash outlay. You sold these 100 shares of ABC Corp. at $30 or $3,000. This totals to −$15 (−45 + 30 = −15) or you paid out $1,500 in cash. Your cost basis of the stock is $45, and your sale basis of the stock is $30, for a net loss of $1,500.
The sale of the ABC Corp. in response to an option assignment creates a taxable event by closing the formerly open position of your option contract. IRS rules require that you increase your sale basis ($30) by the cash option premium you received for selling the opening transaction ($8.50).
In this example, your adjusted sales basis is $30 plus $8.50, equaling $38.50. You sold the stock for a loss of $15 per share, received $8.50 for the option, so you lost $6.50 per share. The out-of-pocket loss is $650. Your equity has gone up more than enough to cover this amount.
The loss for tax purposes is your cost basis ($45 minus your adjusted sale basis of $38.50). This produces a net realized short-term loss (−45 + 38.50 = −6.50). This loss is exactly what the loss would have been if you had done the options buyback.
Your decision was to keep your original stock and buy and sell the new stock on the same day. You have a gain and a tax situation that is the same as though you had used the option buyback offset. Common stock commissions are somewhat larger than option commissions. Thus, the unwelcome option assignment is slightly more costly than the option buyback offset.
Buying new shares when you are exercised (either welcome or unwelcome) gives you the opportunity to selling the higher priced shares to the option holder. In this example, the new shares were higher, so we sold the new shares and kept our lower cost basis. If our cost basis in the original shares was higher, we would sell the older higher cost shares and retain the newer lower cost shares in our portfolio.
Remember, if you sell options on shares of stock that you have held for years and your cost basis is very low, you can always substitute newly acquired shares to comply with the terms of the option contract. You never have to sell your original, low cost basis shares in response to an unwelcome assignment.
You had earlier declined decision one and now you must give an order to your broker. “Buy 100 ABC Corp. at the market and sell those shares just purchased at $30 to satisfy the assignment I have received.”
Now that you have satisfied the call, the underlying stock in your possession is available for writing again. Any stock that went up 28 percent in three months will have caught the eye of the speculators. If you wrote the next period (August calls), and wrote it in-the-money as before, you would get a rich premium.
The ABC Corp. August 40 probably would bring in $5 for intrinsic value and $4.50 for time value, so you probably would get $9.50, or $950. We now have a fresh $950, which more than offsets our previous $650 loss.
When stock price goes down?
When people do not believe in the growth of the company and they sell their shares and withdraw all their money from the stock market. Due to which the company becomes insolvent.
When stock price goes up?
When people’s confidence in the development of the company increases more, then they start buying the company’s shares rapidly. Due to which the share price starts rising. Investors who buy shares at low prices and later sell them at rising prices earn more profit.