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Options Trading: Total Return on Covered Calls

Posted February 24, 2011

Topics: Finance & Investing

How do you calculate returns from writing covered calls? At first glance, this seems like an easy question; return is return, right? But in fact, calculating return can be done in several different ways. The most important aspects to the calculation are consistency and accuracy. Consistency ensures that your side-by-side comparisons are truly comparative. Accuracy ensures that you are taking everything into account to develop a realistic return model.

Five important points determine how you calculate returns and make comparisons, between options written on one stock, or for picking stocks for covered call writing. These are:

Premium: The premium you receive when you sell a covered call is just the starting point of your calculation. This strategy creates extra income beyond what you earn from stock trades and dividends. Covered calls can be closed at any time to take profits, allowed to expire, or rolled forward to avoid exercise. The caution about premium is this: If you pick stocks for covered call writing based on the premium level, it means you are picking the most volatile, higher-risk stocks. This may not be a good match for your risk tolerance. So you should pick stocks based on your criteria, and only then decide whether or not to write covered calls.

Annualizing the return: In order to make sure that your analysis is accurate, you need to annualize the return. In deciding which call to sell, longer-term calls yield more money, but a lower annualized return. In fact, you are going to make a better return selling short-term calls several times per year, than you will by selling longer-term calls for more money. Check this out on any option series, and you will see that it’s true.

            Annualizing is the recalculation of return as if the position remained open for one full year. To annualize, follow these steps:

            1. Calculate the return; divide the premium by stock value (use current value or strike, but be consistent).

            2. Divide the return by the holding period. For example, if the option expires in five months, divide the return by five. If it expires in three weeks, divide it by 0.75 (three-quarters of a month).

            3. Multiply the result by 12 (months) to get the equivalent annualized yield. Remember, though, that the result, which may be double-digit or even triple-digit, should not be seen as what you should expect to earn consistently. This process is used only to make comparisons accurate and consistent.

What is your basis?: You can calculate return based on the cost of stock, its current value, or the strike price of the call. Using the strike price is probably the most accurate, because this is the price at which you are required to sell shares if the short call is exercised. Be consistent. Your comparisons are valid only if you use the same basis in all calculations.

Capital gain on stock: It is crucial that the strike of your covered call is higher than your basis in the stock. This guarantees a capital gain if the call is exercised, and not a capital loss. Pick strikes close to current price per share. Writing a covered call too far out of the money yields very little income. Writing a covered call deep in the money may classify 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: Finally, pay attention to dividend yield. Use the dividend based on the price you paid for the stock. This is a major portion of overall return but often is overlooked. If you are comparing several different companies based on a few criteria, and all are equally promising, go with the one yielding a higher than average dividend.

Michael C. Thomsett is 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.