Covered call writing does three things for the investor: 1) generates tax advantaged incremental income in the form of the premium (CCRA treats the premium on physically settled options as capital gains), 2) lowers risk because the premium reduces the cost base on the underlying stock, and 3) adds discipline to your investment strategy.

The latter point can be viewed as a glass half full or one half empty. The glass half full scenario says that the strike price establishes a point at which you should be willing to sell the underlying stock. The glass half empty scenario says that the strike price limits your upside. To the point that some analysts argue that covered call writing is not a very good long-term strategy, because it effectively removes the best performing stocks in your portfolio.

One of the myths of covered call writing is the so-called rollover affect. The ability to double your money year over year. The idea is to find volatile stocks which, by definition, have high option premiums. Write the at-the-money near-month calls, wait for the stock to be called away, and repeat the process.

Here’s how it works: XYZ, a volatile stock, is trading at $100 per share. Your sell the XYZ
one-month 100 call at $7.00 per share. The shares are called away, you retain a 7% profit and repeat the process. Generate 7% per month consistently, and a $5,000 investment is worth $16.788 million in ten years.

Obviously, the math is most simplistic. For one thing, if option premiums on a particular stock are high, then the market is telling you that it believes there is above average risk in the underlying stock. The relationship is logical, because if a stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay a higher price for the calls. In short – pardon the pun – that same stock also has a tendency to go down, and usually much faster than it rises.

A rolling strategy only works from time to time, in a bull market. In a bear market, it simply doesn’t work. What happens in our example, if XYZ declines to $80 within the next month. What call are you going to write at that point?

The best scenario would see the underlying stock remain relatively flat. But if the stock is locked in a narrow trading range, you won’t get the premium necessary to make the strategy sizzle. Bottom line: writing short-term at-the-money calls is not the right answer for an investor seeking growth. It is better suited to more conservative investors, seeking some downside protection, regular cash flow and a willingness to sell their shares at the strike price of the call.