## Saturday, September 29, 2007

### Calculating Covered Call Returns

In this article I'll describe the math used to calculate covered call (CC) returns.

Let's use the NKE position I opened last week as an example. Prices include commissions.

27-Sep-07 - Initial Stock Position - BTO 100 NKE @ 58.14
27-Sep-07 - Initial Call Option - STO 1 Oct07 57.50 Call @ 1.70

Stock Investment: \$5,814.00
Income Generated: \$170.00
Percent Income Generated: 2.92%
Annualized Income Generated: 48.51%
Net Profit If Called: \$106.00
Percent Return If Called: 1.82%
Annualized Return If Called: 30.25%
Days to Expiration: 22 days

Here's the calculations:

Stock Investment: Stock Price * Number of Shares
Stock Investment: 58.14 * 100 = 5,814.00

Income Generated: Option Premium * Number of Shares
Income Generated: 1.70 * 100 = 170.00

Percent Income Generated: Income Generated / Stock Investment
Percent Income Generated: 170.00 / 5,814.00 = 2.92% (rounded)

Annualized Income Generated: Percent Income Generated / Days to Expiration * 365
Annualized Income Generated: 2.92% / 22 * 365 = 48.45% (approx).

Net Profit If Called: (Strike Price * Number of Shares) + Income Generated - Stock Investment
Net Profit If Called: (57.50 * 100) + 170.00 - 5,814 = 106.00

Percent Return If Called: Net Profit If Called / Stock Investment
Percent Return If Called: 106.00 / 5,814.00 = 1.82% (rounded)

Annualized Return If Called: Percent Return If Called / Days to Expiration * 365
Annualized Return If Called: 1.82% / 22 * 365 = 30.20% (approx.)

Now, some services and investors calculate the returns based on the net cost basis rather than the stock investment. To me, this is double counting the income generated. Here's an example:

Stock Investment: \$5,814.00
Income Generated: \$170.00
Net Cost Basis: \$5,644.00
Net Profit If Called: \$106.00

Percent Return If Called: 106.00 / 5,644.00 = 1.88%
Annualized Return If Called: 1.88% / 22 * 365 = 31.19%

As you can see using net cost basis inflates the returns, falsely I believe, but many services use this method of calculating returns. I'll stick with my method since I believe it more accurately reflects the returns.

Also note that income generated also includes dividends, if any. If you close a position early, just subtract the purchase price of the option from the income generated and substitute the sales price of the stock for the strike price.

That's all there is to it. Just simple math, not rocket science ;-)