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"Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little." - Fred Schwed Jr.

It seems to me that more and more advisors are proposing covered calls as a strategy to increase income or provide some downward protection. Covered calls is a simple strategy to understand. You just sell a call against a stock you own. You make the premium, but lose stock appreciation above the strike level selected.

There's no question that if the stocks are flat or go down that covered calls will generate profit. But, do keep in mind that stock cycles go up as well as down and flat.

Now, in this article, I'm not going to suggest that any single strike level (OTM, ATM, ITM) works or doesn't work. Instead, do Covered Calls, at any strike, really make sense?

My answer is emphatically NO! Let me explain...

First, we must differentiate between the "water-cooler bragging rights investor" and those trying to assemble a portfolio to accumulate wealth or manage retirement. My interest lies not with picking winners but in managing a portfolio. For it is not "one-off" results that determine successful investing, it is overall portfolio returns.

Most investing portfolios consist of a basket of stocks, ETFs and maybe some mutual funds. The investors use their abilities and try to choose each particular investment, adding it into a portfolio that reflects their needs and objectives. For these investors, covered calls are a losing strategy.

We have to dig a little deeper to understand why.

The purpose in developing a "basket" of stocks is to provide diversification. No one actually expects that each and every one of their picks is going to be a hands down winner. They expect some to underperform, some to match and some to outperform the broad market. The objective, of course, is that those stocks that outperform, will outperform by more than those that underperform. If this isn't your expectation, then just put all you money in an index fund and simplify your life.

So, what happens if we write covered calls on each of our positions? Very simply, we make something on the bad picks and cut off the heads of our good picks. We have guaranteed that the winners will not outperform by more than the losers underperform. Look at it this way, the losers still go down by their full amount and the winners don't get their full run-up.

Now some may say that they can pick which stocks to leave alone and just write covered calls on the less optimistic stocks. Well, if you have the ability to pick in advance which ones will do better, then why not just get rid of the bad ones and buy more of the good ones?

I know this might sound cruel, but if your covered call strategy is winning, it's only because your stock picking strategy is losing.

Now before I start a revolt, let me suggest that there is a way to have your cake and eat it too. Sell naked calls on the S&P 500 Index (SPY or SPX).

The reasoning is simple: Your premise is that your portfolio will outperform the market. If not, you would just buy the index. So, if you leave your portfolio alone and sell naked calls on an index, you get the benefits of your planned diversification and the benefits of selling calls - namely extra income and a slight downward hedge.

This is how hedge funds and pros approach the market. They don't buy protection on their stock picks, they buy it on the stock rejects. Professionals are confident (some will say over-confident) their picks will outperform. So they make individual picks and use a corresponding index, or broad based ETF to hedge.

An example... You look closely at Google (GOOG) and Apple (AAPL) and decide GOOG is the better choice. If you are tempted to write a call, don't write it on GOOG, write it on AAPL. If you picked the better of the two stocks, then this method is self evident. If you're afraid to do this, because you might have gotten the stock pick wrong, then the fault lies not in the call writing strategy, but rather the stock picking strategy.

So, the Golden Rule of writing calls is to write them on rejects, not picks.

Here's some examples, if you want the benefits of selling calls...

1) Sell naked calls on S&P 500 for overall portfolio protection

2) Sell naked calls on Powershares NASDAQ ETF (QQQ) instead of AAPL, GOOG, etc.

3) Sell naked calls on SPDR Select Energy ETF (XLE) instead of Mobil (XOM), etc., etc.

If you're not willing to do this, then buy the index, instead of the individual stock.

Summary

In order to benefit from selling calls, one must first understand portfolio creation. The skilled investor, the one that is confident in their stock selection, should avoid covered calls and, instead, look to broad based naked calls.

The less skilled investor, unsure of their stock picks and looking for some extra return, should probably re-examine their stock selecting strategy instead of taking the easy way out with covered calls.

For, in the end, if you've done your best in selecting your portfolio positions, your fear should be a market forces fear, not a diversification fear.

Source: Covered Calls: Finding The Sweet Spot

Additional disclosure: I buy and sell options on S&P 500, AAPL, XOM, XLE, QQQ and GOOG.