When writing covered calls, it’s important to accurately compare one expiration to another, to make certain that your analysis is accurate based on both rate and time. You can compare annualized returns under the following guidelines:
- Make all yield comparisons to the strike. Use the strike for consistency, based on the rationale that if exercised, the strike will be the price at which you sell shares. Alternatives are to base the analysis on your stock basis or current price, but both of these vary and will distort the results. Using the option’s strike makes the most sense.
- Compute the initial yield on a covered call. Divide the premium by the strike. Do this for a range of calls you are considering. If the premium is 3.50 and the strike is 70, the initial yield is 0.05, or 5%.
- Divide the yield by the holding period. For example, if two months remain until expiration, divide the yield by 2. If three weeks remain, divide by 0.75 (three-fourths of one month). Or use actual days; divide the return by days between now and expiration. For example, if the expiration is exactly 3 months away, divide 0.05 by 3 and multiply by 12: 0.05 / 3 x 12 = 20.0%. Or if the remaining days are 92: 0.05 / 92 x 365 = 19.8%.
Why go through these calculations? For consistency. If you are comparing several different calls, each with different expiration time, the initial yield does not tell the whole story. Only through annualizing can you determine which option is the most attractive yield.
What can you expect to discover from this calculation? You will find that shorter-term options yield higher annualized yields and longer-term options yield lower annualized yields. This is the most accurate demonstration of how time value premium declines, and how that decline accelerates as expiration approaches.
As a final step, add the annual dividend yield to the annualized return to find total return. However, this can be further adjusted based on the timing of dividends you will earn. How many quarters will remain between now and expiration in which you will own the stock? In a three-month period for example, it is possible that you will earn no dividends. If an ex-dividend date occurred right before your purchase and the next one occurs three months later soon after expiration (and assuming the call is exercised), you earn no dividends. It is also possible to earn two quarterly dividends in a holding period of just over three months. These variables affect the calculation and comparison between different options. So for complete accuracy, calculate yield, annualize it, and add in the dividends you will earn between now and expiration of the call.