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5 Guidelines: Covered Call Total Return

How do you calculate returns from writing covered calls? At first glance, this seems like an easy question; return is return, right? But in fact, calculating return can be done in several different ways.

The most important aspects to the calculation are consistency and accuracy. Consistency ensures that your side-by-side comparisons are truly comparative. Accuracy ensures that you are taking everything into account to develop a realistic return model.

Five important points determine how you calculate returns and make comparisons, between options written on one stock, or for picking stocks for covered call writing. These are:

1. Premium: The premium you receive when you sell a covered call is just the starting point of your calculation. This strategy creates extra income beyond what you earn from stock trades and dividends. Covered calls can be closed at any time to take profits, allowed to expire, or rolled forward to avoid exercise. The caution about premium is this: If you pick stocks for covered call writing based on the highest possible premium level, it means you are picking the most volatile, higher-risk stocks. This may not be a good match for your risk tolerance. So you should pick stocks based on your fundamental criteria and risk tolerance, as a starting point; and only then decide whether or not to write covered calls.

2. Annualizing the return: In order to make sure that your analysis is accurate, you need to annualize the return. In deciding which call to sell, longer-term calls yield more money, but a lower annualized return. In fact, you are going to make a better return selling short-term calls several times per year, than you will by selling longer-term calls for more money, due to rapid time decay in the last weeks of the option's life. Check this out on any option series, and you will see that it's true.

Annualizing is the recalculation of return as if the position remained open for one full year. To annualize, follow these steps:

a. Calculate the return; divide the premium by the basis (use the strike, not current value or purchase price).

2. Divide the return by the holding period. For example, if the option expires in 35 days, divide the return by 35. If it expires in 14 days, divide it by 14.

3. Multiply the result by 365(days) to get the equivalent annualized yield. Remember, though, that the result, which may be double-digit or even triple-digit, should not be seen as what you should expect to earn consistently. This process is used only to make comparisons accurate and consistent.

3. What is your basis?: You can calculate return based on the cost of stock, its current value, or the strike price of the call. Using the strike price is probably the most accurate, because this is the price at which you are required to sell shares if the short call is exercised. Be consistent. Your comparisons are valid only if you use the same basis in all calculations, and the strike will provide the most reliable form of net return.

4. Capital gain on stock: It is crucial that the strike of your covered call is higher than your basis in the stock. This guarantees a capital gain if the call is exercised, and not a capital loss. Pick strikes close to current price per share. Writing a covered call too far out of the money yields very little income. Writing a covered call deep in the money may classify as an "unqualified" covered call meaning you could lose long-term capital gains status, and end up paying the higher short-term rate.

5. Dividend yield: Finally, pay attention to dividend yield. Use the dividend based on the price you paid for the stock. This is a major portion of overall return but often is overlooked. If you are comparing several different companies based on a few criteria, and all are equally promising, go with the one yielding a higher than average dividend. Be aware that the time between opening a covered call and expiration may involve no ex-dividend dates, meaning you will not earn a quarterly dividend during the option's life. In some cases, you will get one quarterly return or even two. For example, with good timing, you could earn two quarterly dividends in just over 60 days.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership. His new book can be viewed at tinyurl.com/z44kzlu