How much return do you earn from writing a covered call?
The answer: That depends. There are two important qualifying tests you have to apply in order to ensure like-kind comparisons between two or more covered call outcomes. Assume you write two different covered calls on the same day and both expire worthless. Also assume that both were written on stocks you purchased for $5,000, and both earned a premium of $250.
These covered calls both earned 5%. However, that is not the end of the story and, in fact, the return on these covered calls could be vastly different. The comparison is more complicated when two adjustments are taken into account, time to expiration and dividend yield.
The two sets of 100 shares each purchased for $5,000 and both earning a premium of $250 begin looking different when these variables are taken into account. Assume the first expires in 3 months and the second in 8 months. Also assume the first earns 4.1% dividend and the second earns 2.0%.
The 5% return on both of these sets of transactions changes significantly when you calculate the annualized return, and even more when you consider the dividend earned on the stock (so-called "total return" on the covered call). To annualize return, divide the return by the holding period (in months) and then multiply by 12 (months).
Using the examples above:
Covered call # 1: 5% / 3 months x 12 months = 20.0% annualized
Covered call # 2: 5% / 8 months x 12 months = 7.5% annualized
Once annualized the difference is significant. Adding in dividend yield makes an even bigger difference:
Covered call # 1: 20.0% annualized + 4.1% dividend = 24.1% total return
Covered call # 2: 7.5% annualized + 2.0% dividend = 9.5% total return
The total return expressed on an annualized basis is much different for each of these cases. Going through this exercise is essential in entering a covered call transaction. Two important qualifying things come up in this: 1. Dividends play an important role in selecting one covered call and stock over another. 2. Annualizing vastly changes the outcome; however, this should not be used to assume you will always earn the annualized rate, but rather as a means for comparison between two or more covered call choices.
This issue becomes even more complex in the case of exercise. If your covered call has a strike close to your original basis, the capital gain will be minimal. But if your strike is many points above basis, the capital gain will be large. It is not accurate to include capital gains in the selection of stock or covered call calculations. However, it makes the point that picking the best possible strike also affect profitability on not only option and dividend, but also on the stock trade itself.
Calculating option outcomes is challenging and difficult because of the potential variables. One example: If you time a covered call so that its life span includes two ex-dividend dates, you may earn half a year's dividend in just over three months. But if it is timed so that you hit no ex-dates, then the actual dividend yield for that period is zero. This timing issue, coupled with the added problem of how to factor in capital gains upon exercise, make covered call return analysis very tricky, but essential in order to fully understand how to compare outcomes. Once you go through the process of making two or more outcomes equivalent by annualizing returns, you arrive at an accurate comparison between two or more choices.
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website
He also writes extensively on the topic of candlestick charting and has published three books on the topic. You can discover the world of effective chart reading with Profitable Trading Strategies Using Candlestick Charting. This is a comprehensive and complete course on the nature of candlestick charting, offered exclusively by the Global Risk Management Community. By the conclusion of this course, you should be able to locate actionable candlestick signals, better understand what is likely to occur next, and combine candlesticks with other technical signals to forecast price movement. To find out more, go to Using Candlestick Charting
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