"Psst. Hey, I got something for you - the perfect investment.
"It's gonna give you 5% to 7% in income, plus appreciation. It does better than the stocks in down markets, and there's loads of upside potential when stocks are riding high.
"There's options trading, too, but get this: You don't have to worry about 'em - the fund manager's gonna take care of that.
"You in? Just sign here..."
That sounds pretty compelling, right? Income, appreciation, outperformance, and no trades to execute.
There's just one flaw: It's complete crap - and expensive, too.
So, naturally, it's selling like hotcakes, with investors falling for it hook, line, and sinker all over the place.
Let me show you what's really going on with this investing craze - and why you don't want to be anywhere near it.
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How This Bad Idea Works - and Why Wall Street Loves It
There's nothing wrong with writing a covered call here and there if do your homework and you see some profit in it. But full-on covered-call strategies have been pitched as a way to achieve the impossible dream for years.
You buy a stock or exchange-traded fund (ETF), and then sell, or "write," a call option giving the buyer the right to buy your stock at a higher price within a specified time frame.
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If the stock goes above the agreed-on price, then you sell the counterparty the stock and pocket the profit. If the stock is below the stock price at expiration, you keep the stock.
It is a real win-win, isn't it?
Except it's not. In a rising market, you will sell the stock for a few percentage points gain and pocket the premium of a few percentage points at most.
So you make maybe 5%, and then get to watch the stock you don't own anymore soar to new highs.
In a bad market, you save a few percentage points of the decline, thanks to the collected premium. But after that, you participate in all of the drops.
So you see some upside in good markets... and plenty of downside in a bad market.
There's lots of upside for your broker, however. He'll get two commissions: One for the stock buy, and one for the option sale, with the potential for a third payday if the stock is called away.
If you are using a covered-call strategy outside of a retirement plan, you also get to pay taxes on all the legs of the trade.
You see, few options are sold for more than a year out in time, so if the stock is called away, you are taxed on short-term capital gains at the highest possible rate. Same for options premiums - they'll also be classified as short-term capital gains.
I will save you the math lecture on option pricing, but options are richest in times of high volatility. Volatility is usually highest during periods of severe market dislocations that are probably a high-conviction buying opportunity. Selling those seemingly juicy options as prices collapse just means you lose a little bit less than the next guy.
Selling options is least attractive in rising markets, so you are collecting small premiums for the privilege of watching your stock's momentum push them well above the stock price.
Most of the risk, a little bit of the reward. Not smart.
They Want You to Take "Stock Market Risk" for "Money Market Gains" While They Get Paid
The Chicago Board Options Exchange and The Options Industry Council have lots of marketing materials promoting this "high-income, super-safe, win-win" option-selling strategy.
Over the years, I've learned that whatever the people who are making money off my money have a favorite strategy, it's usually a win-win for them and a dubious proposition for me at best.
Now, to compound the stupidity, let's put this strategy to work in a fund where those wonderful, professional money managers, who have historically been average-to-mediocre stock pickers, can work their magic.
They can now buy crappy stocks and sell options against them, "just for you," so you can lock in small profits while being exposed to big losses - and charge you fees averaging 1.5%, to boot.
These funds are pitched as income vehicles with some upside potential. They are very easy to sell to income-seeking investors, and it's easy to get mesmerized by what appear to be fat dividends coming into the account.
However, at the end of the year, they really won't have much more than they started with in the first place. If you look at the PowerShares S&P 500 BuyWrite ETF (NYSE Arca: PBP), it has averaged about 3.3% over the last 10 years.
If you were spending the dividend, which included the premiums received for covered calls, you have less money than you started with in your account.
Contrary to the sales pitch, when you own a covered-call fund, you have almost all of the risk of owning stocks.
The way I see it, if you're going to take the risk, you should gain the reward.
Just buying safe, profitable companies with good dividends has returned around 10% a year over the last decade. Some strategies have returned almost double the market return over that time.
Why take "stock market risks" for "money market gains?"
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About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.