Fans of the free lunch will disappointed to find out that option income isn’t really income—it’s just part of the total return stream of an option income strategy. There’s nothing wrong with option income, but a buy-write strategy is just a way to slightly reduce the volatility of an equity portfolio by trading away some of the potential upside. I get concerned when I see articles promoting it as a way to generate extra income, especially when the trade-off is not fully explained.
According to a recent story in the Wall Street Journal, investors are increasingly turning to option income.
So far this year more than $3.4 billion in options contracts have changed hands on U.S. exchanges, according to the Options Industry Council in Chicago. That’s almost as much as 2008′s full-year volume and is on pace to be the second-best year in options trading history. The all-time record came in 2011 with $4.6 billion in contracts changing hands.
A buy-write strategy to generate option income might make sense if it is part of a total-return strategy. All too often, investors have the wrong idea.
How big of a dent can it make on a portfolio’s long-term prospects? A lot, says Philip Guziec, a Morningstar analyst who studies various options strategies. He recently looked at six years worth of performance data through April 2010 using the CBOE S&P 500 BuyWrite Index, which follows a strategy of selling call options on the S&P 500 Index every month and reinvesting premiums.
During that period, a covered-call strategy where premiums were reinvested would have increased the portfolio’s return by around 19%. By contrast, spending each month’s options payments resulted in reducing the options portfolio’s value by more than 50%, according to Mr. Guziec.
“Too many people sell covered calls to generate extra income to live on, not realizing how severely that type of a strategy can eat into a portfolio’s upside over time,” he says.
Many investors would be shocked to learn that their portfolio could take a 50% haircut in only six years if they spent the option income! As always, the bottom line is total return.
