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Options: Total Return Calculation Can Be Complicated

An option's "total return" combines profits from the options trade with dividend yield. But as straightforward as this sounds, it could be elusive to figure out and to make accurate comparisons.

For example, if you are considering investing in two different companies for the purpose of owning shares and writing covered calls, how to do judge the total return of each?

The first question is estimating profits from the option. Assuming the option is held until expiration and expires worthless, the return is calculating by dividing the option premium (net of trading fees) by the value of the stock. But which value do you use? There are three possibilities: Original price per share that you paid, current value, or the strike of the option.

Because your basis is fixed but current price is likely to change, using the purchase price per share is not accurate. The current price per share is also potentially inaccurate for the same reason. The most logical base to use is the option's strike, because if exercised, that is the exercise price.

Once the potential yield is calculated for an option you are planning to sell as a covered call, the next step is to annualize the return. First calculate the return: option premium / strike

Next, divide the return by the number of days between now and last trading day. Finally, multiply the result by 365 days to arrive at an annualized yield.

Next comes dividends. Considering that the stock is owned, many traders simply add the annual yield. If you use this method, use the yield based on your original purchase price, and not the current yield. The effective yield you earn should be based on what you paid per share, even if that has changed since purchase date.

A further complication arises if you isolate total return to the holding period of the option. Assuming it is held all the way to expiration, how many ex-dividend dates will occur between now and then? In a pure total return, you should count only those dates in which dividends will be earned while you also hold the short call. It is possible with short-term covered calls to have no ex-dividend dates (in fact, this is advisable because early exercise is most likely for in-the-money calls just before ex-dividend). It is also possible to own shares for 58 or 59 days and earn two quarterly dividends.

The number of quarterly dividends earned will drastically affect total return if this method is used. Clearly, the calculation of return from covered calls is less simple than just comparing the dollar value of an option, ignoring dividends, or using the full annual dividend yield. It is true that return, like so many options calculations, has to be figured accurately to provide reliable risk assessment of any trade.

Michael Thomsett blogs at blogs at Options Money Maker, the Top Advisor's Corner at Stockcharts.com and Seeking Alpha and several other websites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others. He currently is working on a new book on the topic of options math, to be published by Palgrave Macmillan in 2017.