The Complexity of Covered Call Return Calculations

What is your return from writing covered calls? The answer: Well, that depends.

In order to accurately calculate your return, you need to set a few rules for yourself. These include:

1. Use the same calculation for all of your covered calls.
2. Compare return for different strikes.
3. Annualize returns to reflect them on the same standard with each other.
4. Take dividend yield into account.

1. Same calculation for all. The "same calculation" refers to the method of calculating the return. For example, if you hold the call to expiration, what is your yield? Do you base it on your cost of the stock, current value, or the strike?

Whichever method you employ, it has to be consistent, and a rationale can be used for any of these. However, the only unvarying standard is the strike, so this is a recommended base for the calculation. If the call were exercised, that would be your sell price, so it should also be your calculation price.

For example, Deere & Co. DE closed on April 6, 2012 at $81.83. The April 82.50 call was at 1.14. To calculate based on the strike, the "if expired" return would be 1.4%:

• 1.14 / 82.50 = 1.4%

2. Compare return for different strikes. In the case of Deere, you can earn more cash by picking a later strike. Comparing April to May and June as of April 6:

• April: 1.14 (1.4%)
• May: 2.50 (3.0%)
• June: 3.75 (4.5%)

3. Annualize returns. Looking at the short list above, it seems as though the later strike is a smarter deal, right? Wrong. When you take into consideration the holding period, you discover that the shorter-term calls yield better than the longer-term calls. This is due to the accelerating time decay when closer to expiration.

If these positions had been opened on April 6, holding periods would be 0.5 months (April), 1.5 months (May) and 2.5 months (June). To annualize, divide the return for each by the holding period, and then multiply by 12 (months):

• April: ( 1.14% / 0.5 ) x 12 = 27.36%
• May: ( 2.50% / 1.5 ) x 12 = 20.00%
• June: ( 3.75% / 2.5 ) x 12 = 18.00%

In this example, you would be better off writing a series of covered calls expiring in one month or less, and repeating 12 times per year, than you would writing a 3-month call four times per year. Annualizing puts all of the positions on the same basis; and while it does not necessarily represent the return you should expect to make consistently, it is a great method for checking accuracy.

4. Take dividend yield into account. If you compare dividend yield for three underlyings that all yield approximately the same on covered calls (and are otherwise equal in the fundamentals), dividend yield can be the great deciding factor. Deere yielded 2.25% as of April 6, not a bad rate for a dividend.

In fact, it is much better than Caterpillar CAT which yielded 1.74% or Cummins CMI, at 1.40%. So if these underlyings were all otherwise equal, picking Deere would make the most sense from a dividend perspective.

Covered call yield is not as simple to calculate as it first appears. So follow these basic rules and make sure your comparisons are fair. Use the same base for all possibilities, compare yield son different strikes, annualize, and compare dividends.

Also be aware that the volatility of the underlying and of the option affects premium value, but also defines differences in levels of risk. The underlying you pick should be a good match for your risk tolerance. Volatility is the most important feature of options, and you can time your entry and exit based on the rapid changes in volatility levels. This can be complex without help, but it can be simple and easy with the right tracking tools.

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