## Monday, May 21, 2007

### Measuring Returns

As you may have noticed in the May 2007 results I reported 2 different measures for my returns over the past 2 years, cost basis and liquidation value.

Here's an example of the two measures.

Let's say the starting amount is \$100,000, fully invested, with a period of 1 year.

Cost Basis Method - Assumes that the stocks will be sold at or above their cost basis, including income generated. In other words, no losses. This is a fairly reasonable assumption since I usually manage each position until it can be closed at a profit and have yet to close a position at a loss over the past 2 years. Now, this doesn't mean I'll never close a position at a loss, just that I haven't had to do so yet.

Cost of stock purchased = \$100,000
Amount of income generated = \$23,860
Total portfolio amount = \$123,860
Annualized Return = 23.86%

Liquidation Method - Assumes that all positions were liquidated at the time of the calculation (i.e. buy back the short calls and sell the long stock). This is not very likely since I have no intention of liquidating these positions.

Cost of stock purchased = \$100,000
Current liquidation value = \$94,380
Amount of income generated = \$23,860
Total portfolio amount = \$118,240
Annualized Return = 18.24%

Notice that the income generated for both measures is the same. The only difference is the liquidation value.

I track the liquidation value, but since I never intend to liquidate my account, I don't pay much attention to it, but I know people will ask so I track it ;-)

The Average Monthly Returns on Invested Capital is calculated using the Cost Basis method. In otherwords, I take the amount of income generated and divide it by the amount of invested capital at the beginning of the option expiration month. It does not factor in the liquidation value of the portfolio. The reason for this is that I'm more interested in the amount of income I can generate than on the liquidation value.

It's important to track one or both of these measures to see how well my portfolio is performing against a benchmark. If I'm beating the benchmark, as I appear to be doing, regardless of which measure you look at, then it justifies continuing to trade according to my plan. If I'm not beating the benchmark, then I either need to change my plan or just invest in the benchmark index or find another investment vehicle. The first benchmark to beat of course is the risk free rate of return, as measured by T-Bills. If you can't beat that, then you're better off just buying T-Bills.

Another method that I use to compare against a benchmark is Standard Deviation of returns and Sharpe Ratio.

The standard deviation of the returns measures the volatility of the portfolio.

The Sharpe Ratio measures the risk-adjusted performance. It's calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

The goal here is to have a higher average return and lower standard deviation than the benchmark (i.e. low risk/high reward = higher Sharpe Ratio).