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Strategies & Market Trends : Covered Calls
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To: tchphysics who wrote (38)5/11/1998 8:06:00 PM
From: tchphysics  Read Replies (1) of 86
 
I'd like to recommend an excellent book to everyone.

"Options for the Stock Investor" by James B. Bittman. It has several excellent chapters on covered calls among other strategies. In it I discovered a couple of new things in calculating returns with covered calls.

In the past I was calculating a return by adding premium and capital gains (income) less option commissions (net income) and dividing that by the total investment cost(cost of stock plus commission).

However, after reading this book, I discovered that your investment cost should also include the effect of receiving an immediate premium (assuming you do a buy-write the same day). In other words, your investment cost is also reduced by the amount of the premium you receive and this has the effect of increasing your return.

For example, if you use $5000 to buy $10,000 worth of stock on margin and sell calls on that stock for a $1000 premium. You have in effect now only committed $4000 of capital to earn that $1000. Not counting commissions (just to make the calculation easier), you might think that your return is 20% (1000/5000), but according to this book, you should calculate instead as 25% {1000/(5000-1000)}. The reasoning given is that you can immediately apply that $1000 toward your margin requirement.

I've adjusted my spreadsheet to account for this method.

The actual formula to use if you are buying on margin is:

return if called = [{(strike price + call premium - stock purch price) * #shares } - stock purch commission - stock sale commission - option commission - margin loan interest ] / (stock purch price * 1/2 (# shares) + stock purch commission - net premium earned)

Probably more than most people want to know, but I found it interesting to note in the book that our returns are higher than you might think, because you are receiving funds immediately in return for your investment.
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