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Covered Calls – Calculating The Net Return

How do you calculate return on the basic covered call?

This is a more complicated question than you might think. Some issues needing to be addressed:

1. Do you include dividend income along with option premium?

2. What stock price value do you use? (Original cost, value at the time the short call is opened, or strike of the call.)

3. What about capital gains on stock? (Clearly, this should not be included, but realistically with one eye on the possibility of exercise, the option strike and expiration you pick is going to be influenced by this concern.)

It makes sense to apply specific names to the different ways of calculating return. And by the way, however it is calculated, comparisons are valid only if you also annualize that return (return divided by holding period, and then multiplied by 12 months). So # 1 above should be called total return; number 2 should be called return on basis, return on current value or return on strike. And for number 3, capital gains should not be added to option and/or dividend income, but should simply be calculated separately. It affects what you pick, but is not part of the return calculation on the option trade.

Consistently is very important, as well as accuracy. Dividend income definitely affects the return. Two otherwise identical covered call yields will vary when one pays 4.5% and the other pays only 1.5% in dividends. So at the very least, dividends should be used as a selection point. As far as which value to use, I prefer the strike for a couple of reasons. First, because original basis will vary widely, it is going to distort outcomes if you use this value as the base for the return. Second, the strike represents the price at which shares will be called away if and when exercised. And you never want to include capital gains as part of the option outcome, although you need to be aware of how gains affect the overall profit picture.

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