Covered Calls: The Complexity of Returns

By: Stephen Bigalow

The following is an excerpt from Stephen Bigalow's Pivotal PROFIT System

Calculating Outcomes

Covered call returns have to be calculated carefully and based on consistent application of a few calculations.  First of all, what is the basis in stock?

Basis can be one of three prices: Your original cost, current market value, or strike price.  Using original cost makes comparisons between strategies unreliable.  Outcomes for greatly appreciated stock versus stock whose price has not moved at all, will not produce results if stock rises or falls dramatically between time of calculation and time the short call is closed.

Using the strike price makes the most sense.  This is the price the call will be exercised if that occurs; it also will be consistent between different versions of the same strategy.  So as a first step, using the option’s strike is advisable to ensure that comparing and tracking outcomes will be accurate.

For example, Google (GOOG) was priced at $492.07 on January 12, 2105.  Two strikes – 495 and 500 – are compared below for two expiration dates based on monthly expirations:

The outcomes can be compared on the basis of initial yield and then annualized.  The results above are based on initial returns only, without considering capital gains.  The indicated number of days are between the subject date of January 12 and number of days until expiration.

To annualize the option returns, divide the return number by the number of days then multiply by 365.  This produces the yield you would earn if the positions were held open exactly one year:

Although the dollar value of later-expiring calls is greater, the annualized yield for the shorter expirations is higher.  This means it would make sense to write a series of shorter-term calls than to execute longer-term ones.  For example, the 495 call expiring in five days yields 60.59% on an annualized basis, compared to above half as much for the February 20 calls.  However, waiting 389 days yields an impressive $1,620 per call, compared to only $410 for the January calls.

Here is how the comparison works out: If you could write a series of weekly covered calls beginning on January 12 (and continuing on 1/19, 1/26, 2/2, 2/9, and 2/16 and all were valued at $410), you would write six calls and yield $2,460.  Compared to the one call 39 days away yielding $1,620, a series of shorter-term calls will be more profitable.  This is why making comparisons on an annualized basis is more sensible.

In this example, the capital gain is based on original cost of stock of $492 (rounded down). The capital gain for each strike is:

So if each of these calls were exercised, you would earn not only the option premium but also a capital gain on the sale of stock.  In calculating outcomes, the annualized yield on covered calls should be performed separately; however, for total return on the entire strategy, these would be considered as well.

Dividends in the Calculation

The third form of income beyond option premium and capital gains is dividend income.  Google does not currently pay a dividend, so comparing this to another non-dividend paying stock does not add anything to the discussion.  However, a comparison of two different companies paying dissimilar dividends reveals another twist in the comparison.

For example, compare Exxon Mobil (XOM) and ConocoPhillips (COP) on January 12, 2015:

To make the comparison between these two accurate, the dividend has to be considered.  The calculation:

The outcome for ConocoPhillips is far superior to that of Exxon Mobil, even without considering capital gain on stock.  The reason for the better outcome is a combination of stock price and dividend yield.  Because COP is less per share but the option premium is similar for each of these, the initial and annualized yield for COP is much higher.  In addition, COP yields 1.5 times higher dividend yield than XOM.