When you write covered calls, greater profits will be earned by writing several two-month positions per year, than from writing one covered call with the longest time to expiration. Time decay for further-out options is quite small, so writing options more than a few months away is equal to lost time. Based solely on option premium profits, focusing on short-term ATM or OTM contracts produces impressive annualized returns.
An example of the covered call and how to identify profit, loss and breakeven points: On June 9, 2015, you bought 100 shares of General Mills (NYSE:GIS) @ $54.25 per share. On July 31, 2015, shares are worth $58.53, a paper profits of $4.28 per share.
You are considering selling a covered call to earn current income. Based on the 4.28 point profit this grants you flexibility in strike selection. Using a strike of 60, you compare two calls. The September 2015 contract (49 days to expiration) is at 0.72. The January 2017 call (540 days) is at 3.05, more than four times more valuable than the September call. Adjusting for trading costs of about nine dollars, the dollar values of these are reduced to about 0.63 and 2.96.
But does this make the later-expiring call more profitable? No. To make these two choices comparable, the net has to be annualized. Based on the strike of 60 as the most consistent and reliable price to calculate net return (as the price the stock will be sold if and when exercised), initial return for each is:
Sept. 2015 call: 0.63 / 60 = 1.05%
Jan. 2017 call: 2.96 / 60 = 4.93%
Because the holding period to expiration is so different for both of these, they can only be accurately compared by annualizing the return. This reflect both outcomes as if the position were left open for exactly one year, or 365 days:
Sept. 15 call: 1.05% / 49 days x 365 days = 7.82%
Jan. 2017 call 4.93% / 540 days x 365 days = 3.33%
This calculation should be performed only for the purpose of comparison, and not to estimate expected overall returns from writing covered calls. However, when comparing these two different contracts, the 49-day shorter-term option is more profitable than the 540-day contract. By writing a series of short-term options, exposure time is shorter and time decay is fast. In fact, during the last two months before expiration, time decay occurs at its fastest rate, which is why the seemingly small net return from short-term covered calls comes out better over time.
Another way to look at the difference is to base annual dollar return on today's value. The 49-day contract yields $63 after transaction costs. If this were repeated 7 times during the year, it would result in $441 of net pre-tax income. In comparison, the $296 earned over 540 days is equal to about $200 per year ($296 / 540 x 365) - less than half the annual net income from writing a series of two-month covered calls.
Michael Thomsett blogs at the CBOE Options Hub and other sites. He is author of 11 options books and has been trading options for 35 years. He also writes extensively on the topic of candlestick charting and offers a course on this topic exclusively on this site.
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