by Dan Keen
After you have done your research homework, and you have found a company that looks like a good candidate for writing a covered call, it’s time for one final consideration. How much money can you make on the play? We have to look at the option premiums and determine the percent return on our money to see if it’s worth playing. A good covered call play is considered to have a high enough premium that will give a 10% or better return in one or two months when the stock is not on margin, and the strike price is slightly out-of-the-money.
What is a good return on your money? The percent return on money is sometimes called the yield. Consider how much interest your money could be making if it were somewhere else. Something nice and safe like passbook savings accounts and certificates of deposits may be paying 3% to 6% annually. Mutual funds may give 10% or better annual returns. So, if you are going to put your hard earned money at risk, you want to get a rate of return that beats these other investments.
Let’s use a real-life covered call play we did to clarify the steps of determining return on investment.
At the beginning of May, we began looking at a company that matched a lot of our criteria. We found a company that had just announced a record 4th quarter; it had a history of five consecutive quarters reporting increased revenue. We bound it by using a free stock screener on the Internet. The company made mid-range computer printer solutions and network integration hardware, and they were introducing new printers that year. The stock was trading at $11.56, which was within our predetermined price range of $10 to $20.
A quick lookup on the Internet of the option prices using the Chicago Board Options Exchange site revealed that the June $12.50 strike price, the next strike price above a current stock price and going one month out, was paying a premium of $1.37 per share.
The stock was selling for $11.56. To do the option play, 100 shares had to first be purchased.
$11.56 x 100 Shares = $1,156.00
The online broker we used charged an $8 commission fee to buy the stock.
$1,156.00 + $8.00 = $1,164.00
Our total cost to buy the stock was $1,164.00
Next, we wrote a covered call for 1 contract (100 shares) for the June $12.50 strike price, and we received a premium of $1.37 per share. We had 100 shares:
$1.37 x 100 = $137.00
Our online broker charged $14.95 commission per option transaction; subtract the commission:
$137.00 – $14.95 = $122.05
We ended up with an income of $122.05 for giving someone the right to buy the stock from us before the third Friday in June (about six weeks) at $12.50 per share.
The percent return on investment is calculated dividing the profit by the cost, then multiplying by 100 to show percent:
Do you consider a 10.5% return on your investment in only six weeks a decent rate of return? If we could write a covered call on that stock every six weeks (about eight times a year since there are eight six-week periods in a year), and get the same premium, that would be the equivalent of 84% annually (10.5% x 8)!
Steps to calculate return on investment for a covered call play if you are not called out.
- Stock price per share times the number of shares plus commission fee = total cost of investment.
- Premium received minus SEC fee, minus commission fee = profit.
- Profit divided by the total cost of the investment times 100 = percent return on investment (if not called out).
When a stock or an option is sold, the Securities Exchange Commission (SEC) charges a fee. It is usually only a few cents for the sale of the stock and as low as one cent for the covered call write. Although these fees are usually negligible, they should be taken into consideration.
What if we get called out, (our stock is “assigned”), and someone buys the stock from us? If we get called out, we received $1,250.00, which is $12.50 x 100 shares, less $14.95 commission, for a total of $1,235.05. Remember, our cost to buy the stock was $1,164.00. Getting called out would generate additional income because we chose a strike price that was slightly out-of-the-money:
$1,235.05 – $1,164.00 = $71.05
Add that to the premium income we have already received:
$71.05 = $122.05 = $193.10
Now compute the percent return on the investment if we are called out:
If we get called out, the return on investment is even better! The advantages, then, of writing a slightly out-of-the-money call are higher premiums and additional profit if our option is assigned.
Steps to follow to determine the percent return when you are called out.
- Stock price per share times number of shares plus commission fee = total cost of investment.
- Premium received minus SEC fee, minus commission fee = profit from covered call.
- Amount of sale of stock minus SEC fee, minus commission fee = net income from sale of the stock.
- Net income from sale of the stock minus total cost of investment, plus profit from covered call = total profit.
- Total profit divided by total cost of investment, times 100 = percent return on investment (if called out).
What are the risks? We get to keep the $122.05 premium regardless of whether the stock goes up or down, or does nothing, and whether or not we get called out. One risk is that the stock might go up to well beyond $12.50, and we would suffer “opportunity lost”. In other words, we might have made more money by just holding on to the stock and not writing a covered call.
Another risk, of course, is that during the period before the option expiration date, the stock price could drop below what we paid for it, $11.56. However, since we were paid over $100 for writing the covered call, the stock could drop to $10.56 and we still would not lose any money; we would break even. Also we would still own the stock. We could hold onto it and hope it goes up in price. Once the option expires, we are free to do as we please with the stock. We could write another covered call for the next month out, if the option premiums give a decent return. That might offset our loss, and even make us more money.