How to Calculate Rate of Return

If your purpose in owning stock is to hold it for many years, writing calls may not be an appropriate strategy—although, in some instances, this strategy can be used to enhance returns with only a moderate risk of exercise. But the call writer's objective often is quite different from that of the long-term investor and, while the two objectives can coexist, it is more likely that you will use the covered call writing strategy on a portion of your portfolio, while avoiding even moderate risks of exercise on another portion.

You have three potential sources of income as a covered call writer:

  1. Call premium
  2. Capital gain on stock
  3. Dividends

This example shows how a potential future profit may be lost, a fact that covered call writers need to accept. Simply owning stock and not writing calls against it could produce profits in the event of a large run-up in price; but it also produces losses in the event of price decline, and selling calls provides downside protection in addition to the certainty of profit.

We have to deal with averages in order to compare straight stock ownership to covered call writing. If we simply hold shares of stock, some will soar in value and others will perform dismally. On average, we may expect to realize a return that beats inflation. For example, the compound rate of return for the S&P 500 from 1926 to 1997 was 12.4 percent. During the same period, the Consumer Price Index averaged 3.1 percent, so stock investments (measured by the S&P 500) beat inflation. If we accept the premise that a portfolio is likely to perform on average at that rate, can we do better by utilizing stocks through covered call writing? Remember, the exceptional stock could return triple digits due to unexpected price growth, and, equally likely, exceptions will involve price declines or stagnation. On average, a compound rate of return should be about 12.4 percent. If we select stocks wisely and employ smart covered call strategies, can we enhance this rate of return? Even given the exceptions on both upside and downside, covered call writing does improve overall returns on portfolios, often dramatically.

Example

Double-Digit Returns: You bought 100 shares of stock and paid $32 per share. Several months later, the stock's market value rose to $38 per share. You wrote a March 35 call and received 8. Your reasoning: Your original basis in the stock was $32, and selling the call discounts that basis to $24. If the call were exercised, you would be required to deliver the shares at $35, regardless of current market value of those shares. Your profit would be $1,100 if that occurred, a return of 34.4 percent. The option premium at the time you sold contained 3 points of intrinsic value and 5 points of time value. If the stock's market value remained at the same level without exercise, that 5 points eventually would evaporate and the call could be closed through purchase at a lower premium. If the stock's market value were to rise far above the striking price, you would still be required to deliver shares at the striking price upon exercise; the potential future gain would be lost. By undertaking this strategy, you exchange the certainty of a 34.4 percent gain for the uncertainty of greater profits later, if they materialize.

A realistic point of view may be to count profits only if they are taken. In other words, potential future profits do not exist at the time to sell an option, and by the same argument, profits in open option positions are not profits unless you close those positions. Covered call writers can earn consistent returns on their strategies, but they also have to accept the occasional lost profit from a stock's unexpected price change. Because covered call writing provides downside protection and discounts your basis in the stock, the strategy also reduces the potential for losses due to short-term price decline.

Smart Investor Tip

When considering the risk of losing future profits that may or may not materialize, it makes sense to also evaluate the potential for future losses from owning stock, and to consider how selling covered calls mitigates that risk.

By accepting the limitation associated with writing covered calls, you trade off the potential gain for the discount in the price of the stock. This downside protection is especially desirable when you remember that you also continue to receive dividends even though you have sold calls.

[caption id="attachment_12490" align="aligncenter" width="380"]A covered call's profit and loss zones. A covered call's profit and loss zones.[/caption]

You also need to study profit and loss zones applicable in every strategy, and one example is shown in Figure above. A covered call's profit and loss zones are determined by the combination of two factors: option premium value and the underlying stock's current market value. If the stock falls below the breakeven price (price paid for the stock, minus the premium received for selling the call) there will be a loss. Of course, as a stockholder, you decide when and if to sell, so the loss is not necessarily realized. You have the luxury of being able to let the option expire worthless, and then wait for a rebound in the stock's price. The option premium discounts your basis, so by selling the call, you lower the required rebound level.

You also need to calculate the rate of return that will be realized given different outcomes. Apply one critical rule for yourself: Never sell a covered call unless you would be satisfied with the outcome in the event of exercise. Figure the total return before selling the call, and enter into the transaction only when you are confident that the numbers work for you.

Total return in the case of exercise includes appreciation of stock market value, call premium, and dividend income. If the option expires worthless, one rate of return results; if you close the option by buying it before expiration, a different return results. Because the second outcome does not include selling the stock, the rate of return can vary considerably. The return is calculated based on the original purchase of the stock. The fact that a different base applies for the different calculations makes a yield comparison elusive. So the relative return calculations should not be used to compare outcomes, but to evaluate your overall risk in entering into a particular covered call strategy. The acceptable strategy is one in which you would be happy with the rate of return in any of the outcome scenarios.

Example

A Table of the Elements: You own 100 shares of stock that you bought at $41 per share. Current market value is $44 per share, and you have sold a July 45 call for 5. Between now and expiration, you will receive a total of $40 in dividend income.

Given this information, return if exercised would consist of all three elements:

Stock appreciation$400
Call premium500
Dividends40
Total return$940
Yield22.9%
If the call is not exercised but expires worthless, total return does not include appreciation from the underlying stock, since it would not be called away. (Current value compared to purchase price is a paper profit only and is not included in the rate of return.) In this case, return will be as follows:

Call premium$500
Dividend income40
Total return$540
Yield13.5%


Although the yield in the second instance is lower, you still own the stock after the expiration of the call. So you are free to sell another call, sell the stock, or continue to hold the stock for long-term appreciation. This makes the point that comparisons between the outcomes are not reliable; they should be used to decide whether you would be satisfied with outcome in either instance.
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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