Are Stock Options a “Free Lunch”?

Some brokers are encouraging their clients to sell Call Options on stocks they own (see here for an explanation of options). The brokers argue that if the stock doesn’t go up you’ll have extra income from selling the option (true) and that if the stock does go up (and the option is exercised) you’ll still make money (true). It sounds too good to be true, and it is.

The problem is that you’re limiting how much money you can make on a stock, but not how much you can lose. In a diversified portfolio it’s normal to have some stocks that do extremely well, and some losers. The gains from the good stocks should offset the losses of the bad ones. When you sell options you’re selling the gains to the buyer of the option but still taking all of the losses.

If the options are priced appropriately then your income from the options should offset the gains you forfeit when options are assigned, making this strategy no better or worse than a buy and hold strategy. However, you will incur three costs that may work to your disadvantage. First, you’ll pay commissions to your broker both for the options contracts and the stock trades that you’ll need to execute to replace shares in your account when they are assigned. Second, the market will pay you less than the options are worth. For example, a sample options contract for Nike can be bought for $375 but you’ll only receive $365 if you sell it. Third, frequent trading will result in all gains being taxed at the higher short term tax rate.

Options may have a place in your portfolio as a way to hedge against losses, but you’ll sacrifice gains some of the time. Over the longer term, there’s no reason to believe you’ll do better with options and you’ll probably do worse.