How To Determine Return (And Downside Protection) For Your Covered Call Trades
If you’re looking to write covered call options, then it’s important have a good idea of two things…
The first is what your trade is likely to return. The second is what level of downside protection the trade gives you. Not only will this allow you to evaluate the trade, but it will also give you a benchmark for comparing it with other opportunities that may be on your radar.
Some online brokers may offer a handy calculator to help with this analysis. But if not, you can also create a handy spreadsheet using the inputs we’re about to discuss.
Below is a screen shot of what this would look like in a spreadsheet. The blue cells represent numbers you enter manually, and the white cells represent data calculated by the formulas.
Explaining The Numbers
The first three cells are fairly clear. For a covered call trade, we enter the market price of the stock, the strike price of the call option that we are selling, and the premium (or price) of the option.
So, for the example above, let’s say we buy a stock that is currently trading at $29.03. We sell a call option contract with a strike price of $28 for $2.09.
Since we bought the stock for $29.03 and sold the option contract for $2.09, our net cost is $26.94. This is also our breakeven price for the trade. So if the stock trades down to $26.94 when the calls expire, we will wind up with a net wash on our trade. (While still holding our stock position, or course.)
The next cell (Net Profit) tells us how much money per share we can expect to make if the stock is called away from when the calls expire. In the example above, our net cost is $26.94. We will have to sell our stock at $28 if the calls are exercised. This represents a net profit of $1.06 per share.
Net profit in nominal terms isn’t very helpful without understanding the actual percentage return. This is what the next cell is for. In this instance, our net profit of $1.06 represents a 3.93% profit over our cost basis of $26.94. Now we have some helpful information to know what level of return we can expect for the amount of capital we are committing to the trade.
The final piece of data that we need to input is the number of days until the contract expires. This allows us to come up with a per-year rate of return estimate. There is a big difference between creating a 3.93% return over a few weeks versus the same return over a year’s time.
To do this, set up the formula so that you can put in the number of days until the calls expire. The formula should take the nominal percentage return and divide it by the number of days until expiration, and then it multiply that return by 365 days in a year. This gives us a rough per-year estimate return.
The final piece of the puzzle gives us the amount of protection we receive from selling the calls. In this example, the stock can drop 7.2% before it hits our breakeven level. This can be a very helpful statistic.
Action To Take
The ability to project various outcomes for options trades can be a handy tool for traders of any level of experience. So if your broker doesn’t offer one, it may be a good idea to find a good online resource (like this one) or simply make your own.
Of course, there are many more detailed statistics that you can run on covered call setups. But this simple table can give you a very quick picture of what to expect for a simple covered call trade.
If you’d like to learn more about making successful covered call trades, then you need to turn to our colleague Amber Hestla. She’s been using this investment strategy to generate payments of hundreds (even thousands) each month over at her premium service, Maximum Income.