How to Calculate
Covered Call Returns

4 Ways to Track Performance When Writing Calls

If you're going to sell calls, it's a good idea to learn how to calculate covered call returns. It's important to be able to track your trading or investing performance in order to evaluate its effectiveness.



There are different ways to calculate the returns on your covered call positions because there are different scenarios.

Note: As far as the IRS is concerned (I'm writing from a United States perspective), covered calls per se don't technically exist. By that, I mean that what you report on your tax returns are the purchases and sales of individual stock and option positions.

In a nutshell, your stock position and your option position are each treated separately.

I'm obviously no tax accountant, so you should always consult with someone who is one for confirmation, clarification, advice, etc.)

But from a personal investing viewpoint, there are different ways to track the performance of your covered call strategies, based on your objectives and preferences.

Here are four such ways:



#1 - How to Calculate Covered Call Income Returns

Calculating the income returns your covered call position generates is pretty straightforward, although there can be variations based on where you set the strike price when writing a call.

I always calculate the potential or maximum income returns a trade will make if everything works out as expected (or hoped). It's important to evaluate beforehand if the potential returns are, for you, worth both the downside and upside risks of covered calls.

So how do you go about doing that? You simply take the net premium received and divide it by the cost of your shares. And then you turn that into an annualized figure.

For example, let's assume you bought 100 shares of a stock at $25/share and wrote an at the money ($25 stike) call expiring in one month. The steps would go like this:

Step #1 - Take the $100 you received in premium and divide it by the $2500 cost of the stock. This works to be an even 4% income return (or yield, if you prefer).

Step #2 - Convert to an annualized rate by taking that 4% and multiplying it by the sum of 365 divided by the number of days until expiration.

If you're confused at all, it's probably easier to understand in formula mode. And, for our example, let's assume the holding period is for 30 days:

($100/$2500)*(365/30) = Annualized Rate of 48.67%

And without the numbers already plugged in:

(Premium Rec'd/Cost of Stock)*(365/Holding Period) = Annualized Income Return

I want to make a few clarifying points in the above example:

#1 - I'm making no commentary either way regarding the possibility or likelihood of making 48% a year writing covered calls - this is just an example with fairly easy numbers to calculate for illustration purposes.

#2 - When making this calculation on your own, always factor in all commissions involved. The cost basis on your stock includes all commissions paid to acquire the stock. Also, be sure to reduce your net premium amount by whatever commission you pay to sell the call. And be aware that if the call gets exercised (i.e. you get assigned), there will also be a commission on that.

#3 - Finally, remember that when you've first set up a trade, these returns are projected numbers - i.e. what would happen if the trade worked out exactly as you've projected it to. But it's only after the trade is completely terminated (by you closing it early, by being assigned, or by the call expiring worthless) that can you confirm the exact numbers and rates of return.

Click here for more indepth information on calculating annualized returns and why I use this metric extensively both for option trade setups and trade management.



#2 - How to Calculate Total Covered Call Returns

Our first example was pretty simple because our only gains were the income gains that were generated from writing the call at the money (or in the money). But what happens when capital appreciation of the stock is also involved?

Let's update the earlier example and find out. Instead of selling an at the money covered call at the $25 strike, let's say we sold one out of the money at the $27.50 strike for $.50 premium.

From an income perspective, would plug our $.50 premium into our previous example and we would get a 2% return over 30 days, or an annualized rate of 24.33% (commissions excluded).

Note: The $0.50 premium is exactly one-half of the $1.00 premium in the first example so it makes sense to assume that the returns would be exactly one-half as well.

But don't forget to consider commission costs.

Here's the principle: the lower the amount of the premium, and the fewer the number of short calls in your position, the greater the impact commissions will have.

But what happens if the stock climbs higher and ends above the $27.50 strike price at expiration? Assuming you don't roll the covered call position, you will be obligated to sell the underlying stock at $27.50/share for $2.50 in realized capital gains (less commissions).

The formula this time around has a few more parts in it, but is still relatively easy to put together: The sum of your net premium received plus your realized capital gains all divided by the original cost basis of your stock.

Or:

(Premium Received + Capital Gains)/(Stock Cost Basis) = 12.00% (in our example)

And to annualize:

((Premium Received + Capital Gains)/(Stock Cost Basis)*(365/Holding Period) = 146.00% (in our example)

Note: This is a pretty aggressive example. Although it does show that writing calls can produce sizable returns, it also shows that what can be a conservative option trading strategy can also be turned into a higher risk option trading strategy.

For more on this, see: How Risky Are Covered Calls?



#3 - How to Calculate Covered Call Losses

Of course, you hope you never have to, but if and when you do realize a loss on your covered call position, it's important to acknowledge and track it.

The key word here is realize. Just because the stock goes down, doesn't mean you've lost money. If your $25 stock trades down to $24, I would still take the income gains and calculate those in terms of the original cost basis.

Of course, you shouldn't hold on to a losing stock simply because you don't want to realize a loss or admit that you were wrong.

Always remember the importance of stock selection when selling calls - see the 5 criteria for finding the best stocks for covered calls for more on this topic.

But let's consider an example where you were clearly wrong about the health of the underlying stock and have changed your mind and are now expecting even more downside. Let's assume the stock really gapped down one morning in the wake of some really unexpected bad news and by the time you reevaluate and decide to sell your shares, it's trading at $17/share.

Let's also assume that you originally wrote your call at the money for the $1/contract premium as in our first example.

In the real world, if you close a covered call early, you're going to have to close the call portion as well as selling the underlying stock. If you don't close the short call along with the stock portion, you would end up with a naked call situation.

Realistically then, it's likely that you would be required to close the short option in order for the stock sale to be approved. And then there are commissions involved which tacks on additional costs to close the transaction.

For simplicity and a real clean example to illustrate the formula, let's assume you get to keep or net the entire $1/contract in premium income, even as you book a $8/share capital loss ($25/share cost less proceeds from selling at $17/share).

At this point, it's an easy (if unpleasant) calculation:

(Stock Proceeds + Net Premium Rec'd - Original Stock Cost) / Original Stock Cost = Net % Loss

In our example, that would be:

($1700 + $100 - $2500) / $2500

Or:

-$700 divided by $2500 or -28.00%



#4 - How to Calculate Covered Call Returns in Terms of Cost Basis

The formulas and methods detailed above are well suited for covered call option traders looking to maximize their returns in the short term as well as for those who write calls primarily for the income stream.

But if you have a longer term investing horizon, and are more interested in approaches to boost your long term portfolio than maximizing gains in the short term (see Investing vs Trading), then you might consider calculating and tracking your covered call performance in terms of cost basis.

This, in fact, is very similar to how I track my own Leveraged Investing results. I call it adjusted cost basis and it basically works like this:

Instead of calculating your realized net premium income as a return, you can instead think of it as a reduction of your original cost basis.



Covered Call Adjusted Cost Basis Example

Let's say your original cost basis on a 100 share stock position was $25/share. And let's further assume that you've been successful in writing out of the money calls for multiple months and that, after six months, you still own the underlying shares and you've also accumulated $3/share in premium income.

With the adjusted cost basis method, you "adjust" your cost basis by the amount of the premium you've booked to date. So in this example, your new adjusted cost basis would be $22/share.

Or look at it this way - you paid $2500 for 100 shares of stock. Since then, you've generated $300 in what might be considered "rebates" so that what you've actually paid for the stock is $2200.

Again, I need to reiterate that this is not an approved tax accounting method, but rather a personal one.

If an option expires worthless, that net premium is considered - and taxed accoredingly as - a short term capital gain.

I love the concept of an adjusted cost basis. I also incorporate it when calculating dividend yield on my long term Leveraged Investments.

Imagine how good it would feel to own some of the highest quality companies you can identify and then lower the cost basis on those holdings by just 5-10% a year. I've referred to this elsewhere as Buy and Hold and Cheat.











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