Compound Stock Earnings Programs: How Much Is Hucksterism?

by: Steve Selengut

The caller seemed surprised that I had never heard about Compound
Stock Earnings Programs, or CSEs. "People are earning three to six
percent per month with little or no risk", she continued, "I'm
thinking of attending a seminar." A wise man once said: "If it sounds
too good to be true, it probably is", but this sure is a creative
euphemism for what has to be a rather complicated options strategy.

The buyer of a "call" option obtains the right to purchase a specified
quantity of a security from the seller of the option, at a stated
"strike price", and at any time on or before the contract expiration
date. When the option seller owns the security, it is called a
"covered" call. The CSE hucksters don't deny that their magic cash
flow system is based on selling "covered" call options, but the "come
on" includes a laundry list of misinformation, partial truths, and
inaccuracies about the stock market and investing.

Covered calls have been around forever, but this is the first time
I've seen them touted as safe investment vehicles. They are certainly
the safest of a complex array of option strategies, but very few
registered, certified, or well known and experienced investment gurus
would ever use the word safe when discussing options--- or recommend
them. All options are speculations, no matter how well sugar-coated
and no matter how fail-safe the trading system appears. The risk is in
there.

Options are bets about the future price movement of exchange-traded
securities--- it's just that simple. The prospect of unusually high
returns always signals unusually high risk. Caveat emptor, in spades.
Here are some things to consider before you think about attending that
free seminar--- not to mention the basic reality that equities are not
at all the proper investment vehicle for an income-generating
portfolio. That's what income securities are all about.

The pitch begins with the accurate statement that most investment
portfolios are chock full of equity mutual funds, and that such funds
rarely produce enough income to pay the bills. Consequently, principal
drainage occurs when mutual fund shares have to be sold during market
downturns. But no mention is made of the fact that really low-risk,
monthly-income, and easily traded alternatives (currently ranging
upward from above 5% tax free and above 7.5% taxable) are readily
available.

The second CSE selling point laments the declining dividend yield on
NYSE traded securities. Again, equities have never willingly accepted
a job description that includes "provide monthly spending money to
shareholders". The purpose of stock ownership is growth in the form of
capital gains. When income becomes the purpose of the investment
program, proper advice would be to sell the stocks and to buy monthly
income producing securities.

Actually, there has never been a time when common stock dividend
yields were as high as some of the CSEs report in their propaganda,
and historical growth rates of the Dow and S & P have always been
calculated ex-dividend. Similarly, the glossies talk about the low
yield on individual bonds and treasury securities as though these were
the only alternatives an investor has, which they obviously are not.
Based on website review alone, it's doubtful that the CSE marketing
companies are registered with the Securities and Exchange Commission
(SEC).

Even if we pretend that an equity portfolio's growth rate can be
enhanced with a covered call strategy, let's look at the things the
investor has to think about after he puts the option premium into his
pocket. What if someone drops the ball (or if something really good
happens over night) and the stock is actually called away? Think of
the tax consequences of a gain on low cost-basis holdings, or the
actual capital loss if you are writing the calls on stocks that have
fallen in price, as you will certainly be doing during corrections.

Additional drawbacks of the covered call program are: (a) limiting the
amount of profit on a rising stock; (b) reducing portfolio liquidity
and flexibility because the underlying securities cannot be sold
unless the option has been bought back; (c) there can be up to four
separate commissions paid in one completed transaction; (d) higher
premiums are generally associated with higher price volatility and
higher risk levels--- which is as it should be. Another possibility is
that the call buyer might exercise his option early in order to
capture the underlying stock's dividend, or because of take-over
rumors.

So as safe as the CSE promoters want you to believe the process is,
there is a significant potential for both loss and inconvenience---
enough so that managed municipal, corporate, and government CEFs,
REITs, preferred stocks, etc. look better and better and better for
investors who need safe (actually safe) income.

While you are thinking about Compound Stock Earnings Programs,
consider this. Why aren't our dear friends on Wall Street pushing
these programs or mass-advertising this revelation? Why are option
specialists the pariahs of most brokerage firm offices? Why are
special risk acceptance forms required by brokerage firms to
separately authorize the use of options? Why are options, commodities,
futures, margin programs, and short selling way up there on most
qualified investment adviser listings of inherently speculative
financial products?

Certainly, the CSE promoters have provided adequate documentation,
instructional material, testimonials, and software to describe the
workings of their covered call option programs. But in addition to the
in-your-face hype, greed food, and numerous pages of disclaimers, can
they show you the customer's yachts?