How to Calculate Annualized Returns on Option Trades

Calculating and Evaluating Your Option Trading Results - And Why It's Important

On this page, I will show you how to calculate annualized returns on option trades and, just as important, I'll also share with you why I believe that calculating your returns (and potential returns) on an annualized basis is superior to simply calculating straight returns.

Determining your annual investment returns is pretty simple. You just take your end of year brokerage account balance, subtract your beginning of year balance, factor out all withdrawals and deposits, and then divide the difference by the beginning value amount (and hopefully, this produces a positive percentage figure).

And calculating a straight return on an individual investment or trade, regardless of the length of the holding period, is likewise a simple prospect. Just take the amount that the investment has increased in value (or decreased as the case may be) and divide that number by the original investment amount.

But when it comes to comparing the performance and potential of individual trades or investments across different holding periods, there's another calculation I prefer (and rely on extensively) - annualized returns.

What is an Annualized Return?

Annualizing your returns simply means that you take your total return generated on a trade and then factor in the length of the holding period in order to determine what that return would be equivalent to if you continued to generate those returns at the same consistent rate over an entire year.

A simple example - if your trade produced a 1% return over a one month holding period, then your annualized return would be 12% (1% per month x 12 months).

The formula used to calculate this annualization follows . . .

Formula for Calculating Annualized Returns

To calculate your own annualized returns, you're basically taking your straight return (returns divided by amount originally invested or at risk) and then multiplying that by how many of your holding periods it would take to make up one year.

That's a pretty inelegant way of explaining it, so let's put it into a formula:

(Returns divided by Capital at Risk) x (365 divided by Holding Period)

Or to see it in a table and spreadsheet format, I've included an example of a single naked put trade on SBUX I did myself:

A	B	C	D	E	F	G
Description	Closed	Opened	Days Held	Booked Income	Implied Risk	Annualized % Return
1 SBUX JUL 16 2011 35 SHORT PUT	7/16/11	5/12/11	65	$89.25	$3500	14.32%
FORMULA ENTERED INTO SPREADSHEET						=(E/F)*(365/D)

How and Why to Use Annualized Returns When Trading Options

Determining your annualized returns is a terrific metric for the trader/investor because it's so versatile:

At the most basic level, when you annualize your returns, it gives you a straightforward way to track your performance.
For example, earning 10% over 9 months is nothing to look down upon, but if I could consistently book 1.5% every 30 days or so, these smaller returns would represent a lot higher rate of return over the longer term.
Now that you know how to, go ahead and calculate these annualized rates and compare the numbers for yourself . . .
I also consider it to be crucial when setting up my own trades.
First, it allows me to easily compare various scenarios (strike prices, # contracts, expiration dates) in order to identify the most appealing trade for me personally. For example, would I prefer to have a 17% annualized rate for 30 days or lock in a lower annualized rate, say 15% over 60 days, or even 12-13% over 90-120 days?
Secondly, determining the annualized returns ahead of time can help me avoid less than ideal trades in the first place. If I run the numbers and I see that my annualized return is only in the single digits, then perhaps I'm not being compensated enough for the capital I'm deploying. Perhaps I can find better opportunities if I'm patient.
And likewise, if the returns are "too good to be true" (especially with longer holding periods), that in itself may be an important red flag that the stock is too volatile to safely trade options on.
Annualization is also an essential tool when managing an option trade.
The way I trade options, trade management typically means one of two things - closing a trade early or rolling it in some fashion.
Closing Early - Sometimes a trade goes in my favor and I can close it early and still lock in the majority of the profits. But in order to make an informed decision, I need a metric that gives me an accurate way to compare my choices.
Comparing the projected annualized return on the original trade with what my annualized return would be if I closed the trade early (and always remember to factor in commissions), can really contrast the choices.
For example, if in my original trade, I projected an 18% annualized return over 45 days, what would I do if I ran the numbers again and saw that I could lock in a 25% annualized return if I closed the trade early at the 20 day mark?
There would be numerous factors involved in the decision, but when I'm able to lock in a significant portion of a trade's potential profit in a fraction of the originally anticipated holding period, then I'll definitely consider it, especially if I see other trading opportunities where I could redeploy my capital.
Rolling and Adjusting - I write a lot of puts on the stock of what I consider world class businesses, and the trades don't always go exactly my way. But because of the structural advantages involved (I essentially keep rolling and adjusting and continuing to book additional option income) I rarely ever book a loss on a trade.
Typically, it's not even a question of profitability or unprofitability - it's more a question of how good or muted the positive returns will be.
And using this annualization method makes it easy to evaluate a roll or adjustment ahead of time.
Just plug in the numbers the same way when rolling (for the booked income field, I use net credit premium - the new premium received on the new short option position less the cost to close out the old short option position).
I can tell pretty quickly if and when it makes sense to roll an in the money naked put (or covered call for that matter) by looking at the projected annualized return produced by the roll.

And sometimes, I'll take a flat annualized return if, on the roll, I'm also able to adjust the strike price (down in the case of in the money naked puts, up in the case of in the money naked calls).

The ability to perpetually roll and otherwise adjust an options position when necessary is what makes option selling, when done correctly and prudently, such an appealing way to extract a lot of money out of the stock market.

Want to Learn More About Stacking the Deck in Your Favor with Options?

I never consistently made money (and good money at that) in the stock market until I started combining trading AND investing. I found that low risk trading could be used in conjunction with the principles of conservative long term investing to both accelerate the investment and reduce your trading risk.

If you want to see what's possible when you combine low risk option trading with low risk equity investing, (and more importantly, why it's possible), then I recommend you check out the following site articles:

Buy and Hold and Cheat

Adjusted Cost Basis

The 3 Types of Value Investing

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