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Options Trading: The Total Return Covered Call Model

Posted January 20, 2010

Topics: Finance & Investing

When you compare returns for covered call writing, what is the potential total return? This is not as easy to calculate as you might think.

You might focus on a comparison between premiums for various choices of a covered call, even on only one stock. But this means you might be overlooking the total picture. Calculating return requires that you consider at least five criteria:

Premium income: The premium you receive for selling a covered call is just the starting point of your transaction. You probably look at writing covered calls as the “cash cow” of your portfolio, and rightly so. It is extra income, above and beyond capital gains and dividends. You can write calls as often as you want, letting them expire or closing them at a profit. You can roll them forward to avoid exercise. Or you can just let exercise happen once a covered call goes in the money.

Annualizing the return: The premium comparison is going to be inaccurate if you only look at the dollar values. In fact, although later-expiring calls will yield more cash, they usually produce lower returns. To make sure your side-by-side comparison is accurate, you need to annualize returns. This is a calculation of what your return would be if the position were left open for one full year. To calculate, divide the dollar amount by your basis to find the percentage of return. Next, divide the return by the number of months to expiration. Finally, multiply the answer by 12 (months). If expiration occurs in less than one year, annualized return will be higher than the simple yield. If the time is longer than one year, annualized return will be lower.

 What is your basis?: This is a complex question. Do you base return on current price of the stock, on your original cost, or on the exercise price? These are likely to be three different prices per share, and the one you pick could drastically influence the answers you find. Any of these methods can be used, although the exercise price (strike) may be the most consistent. It also provides meaningful comparisons of annualized yield if your comparison is going to be based on options with different strike levels.

Capital gain on stock: It is important that the strike you pick for your covered call is higher than your basis in the stock. You want to ensure that in the event of exercise, you will earn a capital gain and not incur a capital loss. You also need to be aware that you should pick strikes fairly close to current price per share, for two reasons. First, if you write a covered call too far out of the money you will receive very little income. Second, if you write a covered call deep in the money, it may be classified as an “unqualified” covered call meaning you could lose long-term capital gains status, and end up paying the higher short-term rate.

Dividend yield: Once you calculate the consistently figured, annualized return from writing two or more covered calls, don’t forget to also add in the dividend yield. to make this complete accurate, figure out how many ex-dividend dates occur between the write date and expiration date; and add one-fourth of the annual dividend rate for each of those dates. Dividend yield represents a large portion of many covered call strategies, often more than half. But it is easily overlooked. Using dividend yield as part of the overall equation makes comparisons more valid and selection easier.