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Calculating Annualized Returns

When writing covered calls, it's important to accurately compare one expiration to another - you can compare annualized returns under the following guidelines:

1. Make all yield comparisons to the strike price that applies if and when the short call is exercised. This is consistent, and appropriate based on the rationale that if exercised, the strike will be the price at which you sell shares. Why not use current value or original cost of share? Current value does not reflect the price at which the shares will be called away upon exercise. And the original cost of shares could be close to strike or many points below, so using cost distorts the outcome and makers comparisons between different trades much less accurate.

2. Compute the initial yield on a covered call. Divide the premium by the strike. Do this for a range of calls you are considering. The result is the initial yield on writing a covered call; and you will discover that shorter-term calls yield a smaller dollar value, but when annualized, produce the best outcomes.

3. Divide the yield by the holding period. For example, if two months remain until expiration, divide the yield by 2. If three weeks remain, divide by 0.75 (three-fourths of one month). Or you can use the number of days between trade date and expiration. In this case, divide the yield by the time remaining until expiration, and then multiply the result by 365.

What can you expect to discover from this exercise? You will discover that shorter-term options yield lower initial returns and dollar values, but also yield higher annualized yields; and longer-term options yield lower annualized yields. The longer the time to expiration, the lower the annualized yield. This is the most accurate demonstration of how time value premium declines, and how that decline accelerates as expiration approaches.

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