Annualizing Models and Guidelines for Options

Annualize returns, not to establish a realistic expectation for outcomes on similar transactions, or to set goals for yourself, but to ensure consistency in comparisons. A discussion of annualization beyond the obvious technique is worthwhile. The basic concept is easily comprehended: If you have two option profits, both at 10 percent, they are not necessarily equal. One held for six months will annualize at 20 percent; another held for 24 months annualizes at only 5 percent. So rather than attempting to compare two options with 10 percent returns, annualization enables you to make a valid time-based comparison.
Clearly, developing a 10 percent profit in six months is far better because (in theory) you can create and duplicate the same outcome four times over a two-year period.

Smart Investor Tip

Annualizing stock-based returns is a smart way to ensure like-kind comparisons. The same principle does not apply to options returns, so annualizing does not provide you with a realistic expectation of future outcomes.

This preliminary view of annualization is completely valid when comparing compound interest in savings accounts, money market funds, or certificates of deposit (or in calculating annual percentage rates on a home mortgage). The time value of money is fairly straightforward for most calculations of the time value of money, which is what annualization is all about. But when it comes to option return calculations, annualization can distort outcomes and even build unrealistic expectations.

For example, a sum of $100 invested in a savings account at 3 percent simple annual interest would grow to $103 in one year. A similar investment in stock may grow to $103 in months and, upon sale, earn the same amount but in half the time. Thus, looking back and comparing these two outcomes, the time value of money invested in that particular stock was twice that of the money left in the savings account.

Time value of money does not take into account varying degrees of risk, and this is where annualization is flawed regarding options. For example, you might take substantial risks in buying a long call for 3 ($300) and seeing it grow to a net of $400 in one month, and achieve exactly the same return writing a covered call and realizing a $100 profit in three months. While the first example annualizes at 400 percent, the second annualizes at only 133 percent. But the risk levels are substantially different, so annualizing does not make these outcomes truly comparative.

Smart Investor Tip

An annualized return can be comparative only when risks are also comparative. As a consequence, you cannot depend on annualized returns for dissimilar positions and expect to gain any reliable conclusions from the analysis.

You achieve a comparative annualized return only when you compare two transactions that are substantially the same, but for different options and stocks and over different time periods. For example, comparing any two long option positions (between calls, puts, or a mix with a call in one case and a put in another) is a substantially identical type of option transaction. The fact that the risk levels are essentially similar lends itself to the use of annualization as a useful device for ensuring that your comparisons are accurate.

You might vary long risks by selecting different timing until expiration, in-the-money versus out-of-the-money positions, or even proximity between striking price and market value of the underlying stock. But the point remains valid: Annualization with options is useful in comparing similar risks. It is not a reliable means for comparing dissimilar risk positions.

Because many option positions are exceptionally short term, it is also not realistic to point to a 400 percent annualized return (or even a 133 percent return) and call it typical. Many options promoters have pointed to such examples to sell seminar "get rich" programs, but that level of outcome is not going to repeat consistently. So another caveat about annualizing is that it should not be viewed as an approximation of returns you can reasonably expect to realize on typical transactions. It is useful as a means of return comparisons only when risk attributes are the same between the transactions annualized.
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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