How do you calculate the rate of return of a covered call when legging in?
I have owned the stock for some time and have made several purchases of this stock over time. Now I am selling a covered call and would like to know how to determine my rate
of return for this trade and of course the annualized rate of return. Your help is much appreciated.
Your rate of return is the profit you earn divided by the amount invested.
If you write an option that is out of the money, you can use the option price as your 'profit.' That's a measure of how much you made by selling the option and ignores whether the stock price moves higher or lower during the period you own the option. The justification for that is that 'I own the stock anyway, so I would have made/lost that amount had I not written the option."
To most, that is not satisfactory. When you write the call option, you don't know what that profit will be. To make an estimate of that profit, you must make some assumptions. You can choose to guess the stock will be unchanged when the option expires. You may decide to assume the option will be assigned and that you sell stock at the strike price. You estimate that profit now, and later, you go back to calculate the actual profit. That includes the profit/loss from the option and the profit/loss from the stock.
b) Amount invested. I believe the amount invested - for the purposes of this calculation - should begin with the price of the stock at the time you write the covered call, because that is the investment you own when writing. Others prefer to use the actual cost of the stock, even if they have owned it for years. That seems wrong to me, but there is no 'official' method for calculating the rate of return for a covered call. You can reasonably use either method for determining how much you invested into the covered call position.
When writing the call, you collect cash upfront. Thus, the amount invested is whichever value you decide to use for the stock - minus the option cash.
c) Example: If you collect $300 for a call option and the stock is worth $3,000 your rate of return is 11% ($300 divided by ($3,000-$300)).
The annualized rate of return assumes you earn the identical profit for one full year.
That number is the (rate of return) * 365/(number of days you held the position).
The 'number of days you held the position' refers to the time from the day you wrote the covered call until
- you close the position
- the option expires
- the option is exercised and you are assigned an exercise notice
Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options
Free eBook: http://www.mdwoptions.com/freebook.pdf