Save covered-call options for fun, not for income

Q My wife and I are both 67. We have money in various traditional IRAs and cash, we own our home, and we have no debt. We have started to take Social Security so that I can reduce my hours from work. I can control my level of work, and I continue to earn enough that I do not need to draw from investments yet.

My questions: What do you think about the use of conservative options trading as an investment strategy during retirement? It seems like a responsible type of investment, but I question how much of my assets I should allocate to this strategy vs. the traditional strategies using asset allocation of respected mutual funds.

TOM, STILLWATER

A You're in a sound financial position and have more investing experience than most. However, it probably won't come as a surprise that I am not a fan of playing the "covered-call option strategy.'' It's promoted as a way to earn a steady income off your stock portfolio. Another way to look at it? You essentially end up with the return of a buy-and-hold investor but pay higher commissions.

First, let's briefly define the covered-call approach. The owner of the stock sells the right to buy it at a set price. The right to buy is called an option. If the stock doesn't hit the set price the option expires and owner of the stock pockets the fee and keep the stock. Not bad, right? Not quite. Problem is, the stock owner has sold away the right to enjoy the equities upside if it goes on a tear. The owner also keeps all the downside risk, although that is cushioned somewhat by the fee income. You'll rack up a bunch of tax obligations with the strategy. The brokerage fees will add up.

That said, I have one recommendation and one suggestion. My recommendation is if you want or need more income, focus on figuring out how much to reduce your equity portfolio. You might also want to consider shifting a portion of your stock portfolio into high-quality dividend-paying stocks. This is an alternative to playing with options.  

The suggestion is go ahead and play the covered-call game if it's fun for you. I would treat it as part of your entertainment spending. Despite my objections, covered calls and the like are a low-risk way to play the stock market. The fees and taxes are simply the price of admission. The trick here is to work with a small part of your equity portfolio so that if it works out well in your favor you'll pocket some extra income (always nice) but if it doesn't it won't make any real difference to your spending budget and lifestyle.

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org

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