Beware the Siren Call of Options Trading

This article should be called "The Novice's Guide to What Options Cannot Do for Your Portfolio." If you have not traded options before and are thinking of getting started, fine, but know that you cannot generate 3%-4% per month by selling covered calls against a diversified portfolio of stocks.

Before I get too deep, the big-picture thought here is that the options market does not give away excess return for nothing. Hold on to that thought and judge for yourself.

The other day I saw a TheStreet.com video with the two authors of a book about generating 3%-4% per month by selling covered calls, and it made me cringe. I do not know exactly what trades the authors make, but I can give the other side of the coin, free of jargon and Greek letters.

In the table below, I list three stocks from four different sectors, going out one month. I tried to look at stocks that I thought were representative of low volatility, medium volatility and high volatility, and for most of them I picked options that were slightly in the money as stated in the interview. In order to get 3%-4% for a month, you need to own a portfolio of hot potatoes, as opposed to a diversified portfolio in which you have a blend of low-beta and high-beta stocks that is consistent with your tolerance for volatility.

The problem is that owning only stocks like Human Genome Science (HGSI Quote - Cramer on HGSI - Stock Picks), Netflix (NFLX Quote - Cramer on NFLX - Stock Picks) and Pacific Ethanol (PEIX Quote - Cramer on PEIX - Stock Picks) is a risky proposition.

What tends to happen here is that the strategy works for a time. You are taking in the premium, your stocks are being called away through option assignments, and all is well. Then one month, you take a little more risk, and it works. Then a month or two later, a couple of stocks go down a little, like maybe to just below the next strike price.

Thus, to get your 3%-4%, you need to sell a lower strike or forgo the 3%-4% by selling a higher strike. In order to make up for it, however, you look for a more volatile stock to make up the difference. But maybe you didn't check out this stock as thoroughly as you should have, and it too goes down.

Then, out of nowhere, the market has some sort of normal correction or a bear market begins. Because all the stocks you own have betas of three, half of your stocks take huge hits, and you give back more than what you made in options premiums over the last umpteen months.

A Few Hot, and Cold, Potatoes These names represent low-, medium- and high-volatility stocks
Sector	Closing Price	Strike	Premium	Time Value	Percent
Healthcare
Pfizer (PFE)	$25.64	25	$1.00	$0.36	1.40%
Genentech (DNA)	$80.79	80	$3.00	$2.20	2.75%
Human Genome Sciences (HGSI)	$12.68	12.5	$0.70	$0.52	4.16%
Financials
JPMorgan (JPM)	$48.30	47.5	$1.35	$0.55	1.15%
Lehman Brothers (LEH)	$76.10	75	$2.95	$1.85	2.46%
CBOT Holdings (BOT)	$160.30	160	$4.30	$4.00	2.50%
Tech
Intel (INTC)	$20.96	20	$1.30	$0.34	1.70%
Google (GOOG)	$480.30	480	$12.90	$12.60	2.60%
Netflix (NFLX)	$27.60	$27.50	$1.10	$1.00	3.60%
Energy
Chevron (CVX)	$75.38	75	$2.05	$1.67	2.20%
Devon Energy (DVN)	$70.68	70	$3.00	$2.32	3%
Pacific Ethanol (PEIX)	$17.11	17.5	$0.80	$0.80	4.60%
Source: Yahoo! Finance