You won't find a simpler strategy than buying and holding quality stocks. But no matter how well something works, you'll always find someone trying to squeeze a little extra out of it.
One example of this is an options strategy known as the covered call strategy. Although this strategy can generate a small amount of additional income from a buy-and-hold portfolio, it comes with risks that many of the brokers and financial advisors who recommend the strategy fail to make clear for their clients.
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How it works
Although options are somewhat complicated -- Fool Jim Gillies took a series of articles to explain their basics -- the idea behind them is relatively straightforward. To use the covered call strategy, you have to own shares of a company that also has listed options available for trading. For every 100 shares you own, the strategy has you sell one call option with an expiration date at some time in the future. Usually, the price you choose at which the option will be exercised -- also known as the strike price -- is above the current market price of the stock.
Here's an example. Say you own 1,000 shares of Microsoft (NASDAQ:MSFT). It currently trades at around $29.50. Your broker might recommend that you write call options that give someone else the right to buy your shares from you for $32.50 per share, anytime between now and the middle of October. At current prices, you'd get paid about $400 for these options -- essentially quadrupling the regular quarterly dividend on your stock.
As long as Microsoft doesn't go above $32.50 before October, that $400 is yours to keep. Looking at the stock's price history, Microsoft has bounced between $22 and $31 for the past five years. What that means is that if you'd used the covered call strategy repeatedly over time, you'd have earned a lot more income in addition to the dividends you got along the way.
Penny-wise, pound-foolish
Skeptical readers will point out that this strategy creates commissions for brokers each time you sell call options. But that isn't the worst thing about covered calls. The main problem with the covered call strategy is that it flies in the face of why you own stocks in the first place. While dividend income can be an important factor in choosing a stock for the long run, a big part of how stocks add value to your portfolio over time is through price appreciation. By using the covered call strategy, you essentially give away your right to future price appreciation above a certain point -- which can be a disastrous mistake in many cases.
To see how covered calls can go awry, look at another example. During most of 2004 and 2005, shares of Reliance Steel (NYSE:RS) were stuck around $20. If you'd used covered calls with a strike price of $25 during that period, you would have earned a lot of additional income. The problem is that when the share price started to rise in the fall of 2005, your calls would have been exercised -- which means that you would have been forced to sell your stock. Granted, you would have turned a nice quick profit, as you'd get paid $25 for shares that had recently traded for $20. But you would have given up all the future gains in the stock. With shares currently trading above $60, your easy $5 profit would have cost you a 3-bagger.
In addition, simply buying and holding your stock lets you decide when you're going to pay tax on any capital gains. As long as you don't sell, you won't get a tax bill. However, if you're forced to sell your shares under the covered call strategy, Uncle Sam will want his share next April. Even worse, if you use covered calls with newly acquired stocks, you might end up with short-term capital gains, which don't qualify for lower tax rates and can more than double the taxes you'd otherwise have to pay.
Hindsight is 20/20
Experts counter that they recommend covered calls only for stocks that trade in fairly tight price ranges. However, stocks can always break out of established trading ranges. Furthermore, with so many stocks with potential for huge price appreciation, keeping a stock specifically because you don't expect it to rise dramatically in price seems silly.
While the income from covered calls may appeal to conservative investors, it's often not worth what you give up. The potential for lost profits, additional taxes, and constant fees makes the covered call strategy questionable for most investors.
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Fool contributor Dan Caplinger has written covered calls from time to time, but he usually ends up disappointed. He doesn't own shares of the companies mentioned in this article. Microsoft is an Inside Value recommendation. The Fool's disclosure policy isn't optional.
