Calculating Covered Call Profits – Not As Easy As It Sounds
Summary:
Calculating profit is the best way to judge and compare trading performance. The return calculation — dividing the dollar amount of profit by the amount invested — is a straightforward way to find the percentage return. Even so, figuring out profits on option trades is much more complicated. This is due to the question of which value to use as a basis, whether to include or exclude dividends, and variations in your holding period.
Click here to learn how to utilize Bollinger Bands with a quantified, structured approach to increase your trading edges and secure greater gains with Trading with Bollinger Bands® – A Quantified Guide.
Definitions:
The return if exercised is the net return from selling covered calls, realized only if and when the short call is exercised and 100 shares of stock are called away. The return if unchanged is a calculation of option profits when positions are closed before expiration. And return if expired is the percentage earned if the option position expires worthless. An annualized return is the adjusted rate of return that is earned from a position if it is kept open for exactly one year.
Profit Calculations:
In calculating profits from long options, the formula is very easy. You buy an option and later sell it. If you make a profit, the amount of profit has to be divided by the original cost to find the percentage return. When you sell options (specifically covered calls), you need to decide whether the return should include dividends earned while you had the option position open, further adjusted by the period of the open option position.
These decisions vastly affect the outcome. However, it is equally important to use a single set of rules when comparing potential option trading profits among two or more different stocks. The richness of option premium, proximity between strike and current price, and dividend rate all affect your potential profit levels.
Taken together, these considerations make calculation of covered call profits more complex than the simple formula. To complicate matters even more, you will need to annualize your return to make all comparisons reliable. The most important single issue is consistency. Even if a method you pick for return calculations is not entirely accurate, it is important to use the same calculations for all option trades. This is the only way to ensure accuracy in the comparison of trade outcomes.
Your basis
The first decision you need to make is what basis to use. For those who buy stock, basis is easy to calculate. It is the price you pay per share of stock. For example, if you buy 100 shares and pay a total, with trading costs, of $5,130, that is your basis. If you later sell those shares for $5,816, your net profit is the difference between sales price and purchase price, divided by purchase price:
($5,816 – $5,130) / $5,130 = 13.4%
In the case of covered calls, what is your basis? There are three possibilities: the price originally paid for 100 shares, the current price per share, or the option’s strike price. Any one of these can be justified:
Original price per share is the true cost of shares. So even though the profit you are going to earn is based on an option’s transaction, the stock’s original price should be used to figure out the profit on the transaction.
The current price per share is a more accurate measure of covered call profits, because this price will determine which strike you select for the trade. The valued of the call itself is also determined by the proximity of strike to stock price.
Strike price is the basis price because if exercised, this is the price at which your shares will be called away. So the call premium should be expressed as a percentage of the strike.
Any one of these can be used as the basis on which to figure your covered call profit. The important issue is not which one you pick, but that you use the same basis consistently. If you vary the calculation between different stocks and different covered calls, you cannot accurately compare outcomes later.
The Return — Its Various Definitions
Your return on covered call trades is going to be different depending on whether the position is exercised, expires worthless, or is closed out before expiration. All three calculations provide you with the means for side-by-side comparisons, a necessity in order to make an informed choice. Which stock should you use for covered call writing? What are the potential maximum profit and loss levels? To decide these questions, you will need to calculate each of the possible outcomes.
For example, if you assume that you will close the short position if the value of the short call falls to 1/3 or lower than the original premium value. For example, you purchase 100 shares of stock for a total price of $5,130. Current value is $5,816. You decide to use the current value of stock as the basis for calculating covered call profits. You also have decided that the short call will be closed if it falls to 1/3 of its premium value. You can sell a 60 call expiring in three months for 4.20 ($420). Based on these assumptions, the calculation of return will be:
Return if exercised means that your 100 shares are called away at the strike price of $60 per share. This will occur only if the current market value rises above this price on or before expiration date. The return if exercised — ignoring both dividend income and capital gains — is calculated by dividing the option premium you received by the share price at the time you sold the call:
$420 / $5,816 = 7.2%
The return if exercised is 7.2% in this outcome. For purposes of comparison, assume that exercise occurred two months after the position was opened, and that no dividends were earned during that time. However, the position was kept open for only three months, so annualized return is going to be much greater. This adjustment to the return is explained in the next section.
Return if expired is often identical to the previous calculation, as long as the position remained open for the same period of time and the premium of $420 was also identical. The difference with expiration is that you still own the 100 shares and you continue to earn dividends during the time the option position was open. For example, if the annual dividend rate for shares was 3.6%, you would have had one ex-dividend date during the period the short option was open. Three months (one-fourth of the year) provides one-fourth of the annual rate, or 0.9%:
3.6% / 4 (months) = 0.9%
If you include dividends earned in your option position rate of return, the position earned:
($420 / $5,816 = 7.2%) + 0.9% = 8.1%
Including dividends is a debatable decision. The primary argument against it is that dividends are related to stock ownership and not to covered call writing. The argument in favor is that in comparing two stocks with equivalent covered call writing potential, it would make more sense to opt for the one paying a higher dividend. As with other discussions of how you make this decision, the most important point is consistency. Apply the same rule to all instances of covered call writing. With that in mind, including dividends makes more sense than ignoring them, so the adjusted return of 8.1% is assumed to be a better choice.
Return if closed varies based on the goal you set. In this example, the decision was made to close a position if and when it lost two-thirds of its original value. So the call you sold for $420 may fall to $140. Upon closing (by entering a “buy to close” order), your profit of $280 represents a return of 66.7% if calculated against the original premium value of the option when it was sold:
$280 / $420 = 66.7%
But if you continue to base net return on the value of the underlying security at the time the position was opened, return is different:
$280 / $5,816 = 4.8%
This makes greater sense, for two reasons. First, it is consistent with the other two calculations. Second, selling the call for $420 and later closing it for $280 is not, strictly speaking, a “return on investment.” You did not “invest” the $420, but received it for selling the call. So calculating the return based only on the option trades is not accurate. Using the share value at the time the short call was opened provides a more accurate and consistent version of “return.” To make comparisons accurately, assume that the decision to close the short call occurred 1.5 months after the original transaction.
A summary of the three calculations:
Returned if exercised 7.2% (2 months)
Return if expired 8.1% (3 months)
Return if closed 4.8% (1.5 months)
Annualizing the Outcome — Short-Term is Probably Better
The previous section’s calculations all represent a holding period of less than one year. Some further adjustment is required because with different holding periods, the calculated return is not the same in each case. The returns have to be annualized in order to express them on the same basis.
To annualize a return, divide the return percentage by the holding period (calculated as the number of months) and multiply the result by 12. In the previous example, the three return outcomes and holding periods were:
Returned if exercised 7.2% (2 months)
Return if expired 8.1% (3 months)
Return if closed 4.8% (1.5 months)
To express these outcomes on a comparable basis, each has to be annualized:
Returned if exercised (7.2% / 2) x 12 = 43.2%
Return if expired (8.1% / 3) x 12 = 32.4%
Return if closed (4.8% / 1.5) x 12 = 38.4%
Clearly, the period a position remains open affects annualized return. The non-annualized calculation makes return if expired look like the most profitable income. In fact, once annualized, return if exercised is far more profitable.
Annualization works no matter whether the period involved is less than one full year or more. For example, consider two separate transactions, one yielding 4.2% with a three-month holding and another yielding 13.2% with an 18-month holding period:
(4.2% / 3) x 12 = 16.8%
(13.2 / 18) x 12 = 8.8%
The smaller initial return was actually more profitable than the higher return held for a longer period. This demonstrates why annualization is so important. However, this process should be limited to making comparative analyses between different option strategies. You should not expect to earn 30 or 40 percent on all of your options trades. Annualization is a useful comparative tool, but not always a safe return expectation level.
You will discover that in deciding whether to sell a short-term or long-term covered call, the lower dollar values of soon-to-expire calls usually yield much better annualized returns than their long-term, higher dollar value counterparts.
A final word on return calculations: Your selection of a specific strike price should always create a net capital gain in the event of exercise. The larger the gap between original basis and the strike, the higher the capital gain. However, it is not realistic or accurate to include the return from the capital gain in the option scenarios. This is a separate matter, even though the selection of the right option will affect the net profit on stock as well.
Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full-time.