Inflated returns?

Written on December 10, 2008 – 10:40 am | by admin

I’ve recently joined a yahoo group that discusses the covered call strategy. Our most recent discussion was about how to calculate returns for a position. They way I currently do it was very different than the way the majority of the people in the discussion did it. The easiest way to explain it is to show you an example.

Buy 100 XYZ at $20.
Sell first month call at the $15 strike for $6.
Sell second month call at the $15 strike for $3.

My old return would have been:
(15 - (20 - 6 - 3)) / (20 - 6 - 3) = 36%
  - This means that each subsequent call would keep reducing my cost basis.

The groups’ standard way:
((15 + 6 + 3) - 20) / 20 = 20%
  - Selling a call never reduces cost basis.

The groups’ standard way of calculating return is fine if the initial transaction was never intended to be a CC and you just sold an OTM call to generate extra income. The problem I have with this is that it doesn’t really show the real capital at risk in a CC transaction.

My new way:
((15 + 3) - (20 - 6) / (20 - 6) = 28.5%
  - Only the call sold in tandem with buying the underlying stock reduces the cost basis. My reasoning is that I wouldn’t have done the transaction if I couldn’t get protection down to a certain point (reducing my risk). After that, its just like holding any other stock position and selling any calls in months 2 -> n is just extra income.

I have not changed the way I am calculating annual yield as I still think basing it on the months per year instead of days is better since a CC stock is locked up for 1 month at a time.

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