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Covered Call – Calculating Total Return

How much return do you earn from writing a covered call?

The answer: That depends. There are two important qualifying tests you have to apply in order to ensure like-kind comparisons between two or more covered call outcomes. Assume you write two different covered calls on the same day and both expire worthless. Also assume that both were written on stocks you purchased for $5,000, and both earned a premium of $250.

These covered calls both earned 5%. However, that is not the end of the story and, in fact, the return on these covered calls could be vastly different. The comparison is more complicated when the following adjustments are taken into account:

Description Covered call # 1 Covered call number 2
     
Cost of stock $5,000 $5,000
     
Premium earned 250 250
     
Time until expiration 3 months 8 months
     
Dividend yield 4.1% 2.0%

The 5% return on both of these sets of transactions changes significantly when you calculate the annualized return, and even more when you consider the dividend earned on the stock (so-called "total return" on the covered call). To annualize return, divide the return by the holding period (in months) and then multiply by 12 (months).

Using the examples above:

Description Covered call # 1 Covered call number 2
     
Yield 5% 5%
     
Holding period 3 months 8 months
     
Annualized return    
( 5.0 ÷ 3 ) x 12 20.0%  
( 5.0 ÷ 8 ) x 12   7.5%

This is a considerable difference in net return. Annualizing makes this two outcomes comparable because the return is expressed as if the position was open exactly one full year. Dividend yield is a significant portion of covered call return.

In this example, the dividends were also substantially different:

Description Covered call # 1 Covered call number 2
     
Yield 5% 5%
     
Holding period 3 months 8 months
     
Annualized return    
( 5.0 ÷ 3 ) x 12 20.0%  
( 5.0 ÷ 8 ) x 12   7.5%
     
Dividend yield 4.1% 2.0%
     
Total return 24.1% 9.5%

The total return expressed on an annualized basis is much different for each of these cases. Going through this exercise is essential in entering a covered call transaction. Two important qualifying things come up in this: 1. Dividends play an important role in selecting one covered call and stock over another. 2. Annualizing vastly changes the outcome. This becomes even more complex in the case of exercise. If your covered call has a strike close to your original basis, the capital gain will be minimal. But if your strike is many points above basis, the capital gain will be large. It is not accurate to include capital gains in the selection of stock or covered call strike. However, it makes the point that picking the best possible strike also affect profitability on not only option and dividend, but also on the stock trade itself.

Calculating option outcomes is challenging and difficult because of the potential variables. One example: If you time a covered call so that its life span includes two ex-dividend dates, you may earn half a year's dividend in just over three months. But if it is timed so that you hit no ex-dates, then the actual dividend yield for that period is zero. This timing issue, coupled with the added problem of how to factor in capital gains upon exercise, make covered call return analysis very tricky - but essential in order to fully understand how well your outcomes are succeeding. Once you go through the process of making two or more outcomes equivalent, you see how useful it is to annualize and to include dividend yield.

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