Calculating the Rate of Return for Sellers

You are guided by your rate of return in all of your investments. In a single transaction involving one buy and one sell, rate of return is easily calculated. Simply divide the net profit (after trading fees) by the total purchase amount (including trading fees), and the resulting percentage is the rate of return. When you sell options, though, the rate of return is more complicated. The sale precedes the purchase, so rate of return is not as straightforward as it is in the more traditional investment.

Rate of return can only be looked at in comparative form.

In other words, comparing one short position outcome to another, given dissimilar holding periods, makes the comparison invalid. The calculation should be adjusted so that all short position outcomes are reviewed and compared on an annualized basis. Because different lengths of time can be involved in a short position—from a few hours up to several months, or even two to three years if LEAPS are involved—it is not realistic to compare calculated rates of return without making the adjustment. A 50 percent return in two months is far more significant than the same rate of return with a 10-month holding period.


Example

When 12 Percent Is Not 12 Percent: You realize a net profit of 12 percent on an investment. The annualized rate of return will vary depending upon the holding period.
  1. Three months:Net profit 12%
    • Holding period = 3 months
    • 12 ÷ 3 = 4%
    • 4% × 12 months = 48% annualized
  2. Eight months:Net profit 12%
    • Holding period = 8 months
    • 12 ÷ 8 = 1.5%
    • 1.5% × 12 months = 18% annualized
  3. Fifteen months:Net profit 12%
    • Holding period = 15 months
    • 12 ÷ 15 = 0.8%
    • 0.8% × 12 months = 9.6% annualized
To annualize a rate of return, follow these steps:
  1. Calculate the rate of return. Divide the net profit by the amount of purchase.
  2. Divide the rate of return by the number of months the investment position was open.
  3. Multiply the result above by 12 (months).

As these examples demonstrate, annualized rate of return differs dramatically depending on the period the position remained open. Annualizing applies for periods above one year, as in example number 3. A short period is properly extended though annualizing, just as a period beyond one year should be contracted to reflect rate of return as though the investment were held for exactly 12 months. By making all returns comparable, it becomes possible to study the outcomes realistically, not to calculate your true average yield but to better be able to analyze outcomes side by side. Annualizing can also produce exceptional but unrealistic results. So annualizing is valuable for making accurate comparisons, but it will not necessarily provide you with a realistic future average return using options. You should accept the possibility that you will experience a range of outcomes from options trading; some profits materialize quickly, and others take a long time. Some strategies will also produce losses.

Example

Fast Turnaround: You recently sold a call at 3 and, only two weeks later, closed the position by buying at 1. The profit, $200, is 4,800 percent on an annualized basis (200 percent return dividing by 0.5 month, and multiplied by 12 months, or [200 ÷ 0.5] × 12). This is impressive, but it is of little use in your comparative analysis. Not only is it atypical of the returns you earn from options trading, but it also reflects an exceptionally brief holding period, which you probably cannot duplicate consistently.


Smart Investor Tip

Annualized basis is helpful in judging the success of a series of transactions employing a particular strategy. It is less useful in looking at individual outcomes, especially those with very short holding periods.

The calculation of return is made even more complex when it involves more than return on the option premium. When you sell calls against stock you own, you need to adjust the comparative analysis to study the likely outcome based on two possible events. The first is called return if exercised. This is the rate of return you will earn if your short call is exercised and 100 shares of stock are called away. It includes both the profit on your option and profit or loss on the stock, as well as any dividends you received during the period you owned the stock.

The second calculation is called return if unchanged. This is a calculation of the return to be realized if the stock is not called away and the option is allowed to expire worthless (or it is closed out through a closing purchase transaction).

In both types of return, the calculations take into account all forms of income. The major difference between the two rates has to do with profit or loss on the underlying stock. These factors complicate the previous observation that comparisons should be made on an annualized rate. It is extremely difficult to account for each dividend payment, especially if the stock has been held over many years. In addition, how do you account for the return on stock held but not sold?

Neither of these analytical tools lends itself to annualized return, which is a valuable tool for the study of relatively simple transactions involving only one source of income. The return if exercised and return if unchanged are far more valuable as a method for determining the wisdom of a decision to sell a call in advance of actually taking that step. By comparing these potential rates of return, you can determine which options are more likely to yield profits adequate to justify tying up 100 shares of stock with a short call position.

The actual steps involved in calculation should always be net of brokerage fees, both for sale and purchase. Remember that no attempt should be made to make comparisons on an annualized basis, however, because complex transactions with differing types of profit, and generated over different lengths of time, make annualized return inappropriate. While the following examples use single-option contracts, in practice options traders often use multiple options and involve more than 100 shares of stock.

Example

Many Happy Returns: You own 100 shares of stock that you purchased originally at $58 per share. Current market value is $63 per share. You sell a call with a striking price of 60 and receive a premium of 7. Between the date the option is sold and expiration, you also receive two dividend payments, totaling $68.
Return if exercised:
Striking price$6,000
Less original cost of stock-5,800
Profit on stock$200
Dividends received68
Call premium received+700
Total profit$968
Return if exercised: ($968 ÷ $5,800) = 16.69%
Return if unchanged:
Call premium received$700
Dividends received68
Total profit$768
Return if unchanged: ($768 ÷ $5,800) = 13.24%
This side-by-side calculation allows you to see what will happen in either outcome. In the example, it comes down to a difference of about 3.5 percent between the two outcomes. So the question becomes, would it be worth that small difference to accept exercise? In the alternative, would it be better to close out the position before expiration and repeat the transaction subsequently? By avoiding exercise, you can sell a later call and expand profits even further, which should also be considered when comparing these two possible outcomes.

The comparison between "if exercised" and "if unchanged" is further complicated by inclusion of capital gain on the stock. Because one calculation includes this and the other does not, the two outcomes are not truly comparable. Based on the striking price you pick when you sell a call against 100 shares of stock you own, a capital gain could be minimal or quite significant; exercise could even end up with a capital loss. So the gain on the stock cannot be entirely ignored.

Even so, the comparison including stock does distort any attempt to make a true comparison. Ideally, you should consider the corresponding gain or loss on the option only, and separate out capital gains or losses on the stock separately. This is inaccurate, of course, but making valid comparisons of potential outcomes is difficult. Calculating the Return: A Complex Aspect to Options examines return calculations in more detail, because the difficulty involved makes it especially complex.

Another important factor in this example involves taxes. Because the example includes selling an in-the-money call, the capital gain may be treated as short term. As part of your option strategy, any short positions have to be made with a tax calculation in mind. Tax strategies are explained in Risk and Taxes: Rules of the Game. A net profit comparison should always include brokerage fees and both federal and state tax consequences, which are going to vary by individual as well as by state.

Annualizing the returns if exercised or if unchanged is not recommended because the transactions involve three different time periods: for stock, dividend, and short position in the call. In addition, the purpose here is not to compare results after the transaction has been completed, but to make a comparison in advance to determine whether the transaction would be worthwhile. You can use these calculations not only to compare the two outcomes, but also to compare outcomes between two or more possible option short positions.

Smart Investor Tip

The purpose in comparing returns on option selling is not to decide which outcome is more desirable, but to decide whether to enter into the transaction in the first place.

Succeeding in options trading means entering open positions with complete awareness of all possible outcomes and their consequences or benefits. You need to know when it makes sense to close out a position with a closing transaction, avoid exercise with subsequent trades, or just wait for expiration. You also need to be aware of market conditions and the timing of options trades, as well as the relative degree of risk to which you are exposed by entering into open options positions. Knowledge about potential profit is only part of a more complex picture. The more you study options and participate in the market, the more skill you develop in making an overall assessment and comparison.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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