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Options Trading: The Deceptive Returns of Covered Calls

By  Apr 2, 2011

Topics: Finance & Investing

Which covered call produces the best yield? It is easy to think a later-expiring call with more time value is a better choice. But in fact, you are going to make more profit by selling shorter-term contracts for less cash, several times per year. It all comes down to figuring and comparing profits on an annualized basis.

Time decay is what makes short-term covered calls more profitable. Because it declines at an accelerated rate during the last two months before expiration, those short-term calls are going to yield much greater returns. So over a year, it makes sense to write six 2-month calls than it does to write three 4-month calls.

Selecting the best call requires several steps. First, the strike should be higher than the price you paid for stock. So in the event of exercise, your stock will be called away at a profit and not at a loss. So a strike has to be higher than your basis, and ideally also slightly higher than the current value of stock. For example, if you bought stock at $43 and it currently is worth $47, selling a $47.50 covered call meets this requirement. The strike is 4.5 points ($450) higher than your cost, and it is also 0.50 ($50) out of the money. The premium has zero intrinsic value.

Second is duration. You might see that a call expiring in two months is currently worth 3.25 ($325), but the one expiring in five months is worth twice as much, or $650. Isn’t it better to get more? No. Compare both on an annualized basis.

Using the same example as before, calculate annualized return using the strike, or $47.50 per share. The two-month call yields:

                        3.25 ÷ 47.50 = 6.8%

The five-month call yields:

                        6.50 ÷ 47.50 = 13.7%

 Now recalculate on an annualized basis, or the return you would earn if a position were left open exactly one year. To do this, divide the initial return by the holding period (in months) and then multiply by 12. The two calculations above are revised to:

                        ( 6.8 ÷ 2 ) x 12 = 40.9%

                        ( 13.7 ÷ 5 ) x 12 = 32.9%

Annualized return should not be viewed as typical of what you should expect to earn consistently in writing covered calls. However, it is a valuable method for picking one contract over another. You are going to earn a better yield writing very short-term options due to the rapid decline in time value. This also means those calls are less likely to get exercised. They can be closed at a profit more quickly, or rolled forward to avoid or delay exercise.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.