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), Netflix ( NFLX) and Pacific Ethanol ( PEIX) 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

I saw this happen with many people during the deflation of the tech bubble, and it will happen again but in a way that is slightly different from before, catching many off guard. The real pitfall here is that the amount of options premium becomes the most important criterion for stock selection. I'm sure this is not what the authors have in mind, but human nature is what it is.

To repeat from above, the market does not give away excess return for nothing. If the options market will pay 4% for a month of time, it is because the stock has a lot of risk. Some names like that in a portfolio make for good diversification, but a portfolio of 30 names like this makes for some real anguish at some point.

I know that there are people doing this type of trade successfully, and they may never have to face up to the consequences of the risk they are taking, but they are taking the risk nonetheless.

Covered calls can be a way to add some extra yield to a portfolio, but the mindset needs to be much different from that of someone looking for 3%-4% per month. When I say extra yield, I am thinking in terms of adding another 100-200 basis points to the overall dividend yield of the portfolio for the year.

For investors who are typically 1,000-share buyers of stock, they could sell call options on 200-300 shares on some stocks a couple of times throughout the year and achieve this little boost (no guarantee!) without altering the risk profile of the account. By only selling calls on a small portion, you are allowing the stock to run if something positive happens.

The point I am trying to make is one of moderation. Too much of anything, no matter how good, is, in fact, bad. Really, most people are better off without options, but if you want to dabble and are new to this trade, just realize that the options market does not give away money for free.

At the time of publication, Nusbaum held no positions on the stocks mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

More from Options

Comcast Drops Bid, Disney Call Prices Pick up

Comcast Drops Bid, Disney Call Prices Pick up

United Continental Call Prices Fly After Earnings

United Continental Call Prices Fly After Earnings

How to Trade General Electric's Stock After Earnings for Superior Gains

How to Trade General Electric's Stock After Earnings for Superior Gains

6 Chip Stocks to Play Into Earnings

6 Chip Stocks to Play Into Earnings

Why VF Corp. Call Prices Doubled, Before Earnings

Why VF Corp. Call Prices Doubled, Before Earnings