Placing a covered call sets up a potential profit. We cannot know the final trade results upon entry, thus covered call lists typically show covered call returns as flat and called.
The flat return (static return) assumes that the stock price does not change by expiration.
We assume in calculating the flat return on ITM calls (in-the-money calls) that the writer will be assigned (called), and on ATM (at-the-money calls) and OTM (out-of-the-money calls) that the writer will not be assigned.
The called return (a/k/a return if-called or return if-exercised) on the other hand assumes that the writer is assigned an exercise no matter whether the calls are ITM, ATM or OTM.
The budding covered call writer must understand these facts about the different call strikes, which explain why covered call lists always show the same called and uncalled returns for ITM and ATM strikes:
- ITM and ATM – the flat and if-called returns always will be the same;
- OTM – the if-called return will be higher by the amount the call is OTM;
The calculation of return in a covered call trade is based solely upon the time value portion of the premium.
If a premium is all time value, then it is all return. Thus you must know the time value in order to calculate the return. The if-called return also includes the extra profit realized from being assigned on an OTM call strike.
There probably is no more common mistake in assessing returns than to look at a fat ITM premium and forget that part of it is intrinsic value.
In a Call Strike Analysis example where the ITM premium is $3.25, it may seem large. But if $2.67 of it is intrinsic value and only $0.58 of it is time value, the return is not as good.
While the $3.25 of total premium provides nice downside protection to $16.92, the return will be calculated on the 0.58 of time value.
Further, the covered call return is computed upon the net trade debit (S-C), the cost basis after buying the stock and writing the call, because that is the amount at risk. The following two tables demonstrate the calculation of flat and if-called returns.
|Flat Return Calculation:
The flat (static) return is the potential return on the covered call write assuming that the price of the underlying stock has not changed by option expiration. If the calls are ATM or OTM, it assumes they are not exercised; but if the calls are ITM, their exercise is assumed.
Return = Time Value Premium / Net Debit
1) Determine call’s time value (premium – intrinsic value)
2) Determine net trade debit (stock price – total call premium)
3) Divide time value by the net trade debit (time value ÷ NTD)
Example: The stock costs $19 and the 17.5 Call is sold for $2.50. After computing the call’s time value ($1.00, since the call is $1.50 ITM), simply divide the time value by the net trade debit.
|Return If-called Calculation:
This is the return the trader will realize if the short calls are exercised and the underlying shares are called out. This is also known as the return “if assigned” or “if exercised”.
Return = (Time Value Premium + Profit on Exercise) / Net Debit
1) Determine time value and net trade debit, as above.
2) On OTM calls, add additional profit to time value if stock is called;
3) Divide sum (additional profit on exercise + time value) by net trade debit.
Example: The stock costs $19 and the OTM 20 Call is sold for $1.25. Being OTM, the call’s premium is all time value. If the stock is called out at the $20 strike price, the writer keeps the original $1.25 in premium and gets an additional $1.00 of profit. To calculate the return if-called, add the $1.00 of additional profit to the $1.25 time value and divide that $2.25 sum by the net trade debit.
NOTE: if the stock is higher than $19 but is $20 or less at expiration, the writer will not be called
The returns presented on covered call lists are only potential returns. The actual return is known and realized only upon conclusion of the trade, because much can happen between trade entry and exit.
Moreover, there often are profits to be made from trading the calls as well as writing them. The call writer is at risk for the entire duration of the trade.
This is the key reason that savvy call writers always look for profitable opportunities to unwind a trade early if the profit from doing so is acceptable (discussed later on).
Norming Returns to a Monthly and Annual Basis
It is fun, and useful, to convert any trading return realized to a monthly or annual basis in order to see how on-track you are to make your target annual return. The tables in Figure 4.9 below show you how to quickly convert the raw return into a monthly and annual return:
1) Divide the % return by no. of days in the trade
2) Multiply by 30 = monthly return
1) Divide the % return by no. of days in the trade
2) Multiply by 365 = annualized return
The annual and monthly returns thus calculated are not meaningful in and of themselves. A 390% annualized return feels good, but the usefulness of norming is that it allows us to compare returns achieved over different time periods. Both calculations serve the purpose.
Cost Basis (Breakeven)
Cost basis is the net trade debit incurred in a covered call after buying the stock, paying the trade commission and receiving the call premium; that is, S – C – Comm.
The net debit also the position’s breakeven point, the price below which sale of the stock will produce a loss. Intrinsic value is ignored in calculating the net debit, since the net debit is the stock cost minus total premium received and costs.
Example: Assuming the trader pays $19 for the stock and sells the 17.50 call for $2.50, the cost basis will be $16.50. Intrinsic or time value does not matter; cost basis is the net cost of the trade.
Stock price paid $19.00
Less premium rec’d – 2.50
Cost basis $16.50 (the nominal breakeven point)
The “Breakeven” is not the True Breakeven Point:
Consider: the net trade debit is never the true breakeven point, if the covered call trade is to be closed early. Here’s why:
- Closing the Calls: There will always be a cost to buy back the short calls in order to close the position, and call prices never go to zero before expiration. The cost of buying the calls to close must be added to the breakeven in order to get the true breakeven cost.
- Commissions: There will always be two commissions involved to close the trade, and these must be figured into the realistic breakeven.