Every Wednesday, we publish our “Investor Toolkit” investing advice series. Whether you’re a new or experienced investor, these weekly updates are designed to give you our specific advice on successful investing. Each Investor Toolkit update gives you a fundamental piece of investing advice and shows you how you can put it into practice right away.

Tip of the week: “Covered-call writing will likely cut short your gains.”

Stock option investing includes selling options; covered call writing is where you sell a call option against a stock you currently own. You receive cash for selling the call, but are obligated to sell the stock at a fixed price (the “strike price”) if the holder of the call exercises the option.

Covered-call option writing is sometimes recommended by brokers as a way for investors to increase income from their stock holdings. In my view, however, covered call writing (or any involvement with stock option investing) tends to act like an unintended profit filter. It can occasionally make you money and it may cut your risk, but the net long-term effect is to filter out a big part of the profit you hoped to wring out of your investments.

Here’s the sales pitch: You hold shares of a company that you think will remain at around today’s price for some time. You’re reluctant to sell the stock, however, because you like its long-term appeal, or possibly because you’d have to pay capital-gains taxes. If you sell call options on your stocks, you’ll pocket low-risk premium incomeeven if your stock just sits there. This strategy will not only generate extra income, but will lower risk and volatility.

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Stock option investing: Covered calls force you to sell winners too soon

Things rarely work out that way, however, if only because stock price moves are sporadic.Of course, it’s possible to invest in such a way that you earn substantial capital gains over a period of years. However, the performance of any particular stock over any given period is largely unpredictable. But it’s even harder to predict which stock in a group of stocks will turn out to bea top performer. After all, if you could spot the top performers ahead of time, that’s all you’d buy, and you would quickly become extremely rich.

What’s more, by consistently selling covered calls on your stocks, you’ll eliminate all chance of being in on a big gainer. If you feel certain your stock is not going to rise in price, you should sell it.

If you sell calls on your stocks, the option holder will of course exercise the call and buy any stock that performs well. So you will wind up selling every stock you own that moves up.

In addition, if you have sold a call on a stock, you will probably want to hang on to it until the call expires. Otherwise, your calls are no longer “covered” and you expose yourself to far more risk. So if you sell calls on your stocks, you wind up holding on to stocks that go sideways or downwards, while selling those that go up. It’s a recipe for investment mediocrity if not disaster.

Covered call writing may sound like a perpetual money making machine – and it is, but only for the broker. Call-writing programs can generate total commissions of 5% to 10% or more of an investor’s capital, every year. So you’d need to consistently generate pre-commission profits of, say, 15% to 20% per year, or more, to earn a substantial return. But if you were capable of that, why bother fooling around with options?

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