In a previous post (’Ten Factors’ link), ten factors were identified that are used by this Covered Calls Advisor to analyze potential covered call positions for investment worthiness. Of these ten however, two primary factors were identified as being particularly important to us covered call investors:
1. Annualized Return-On-Investment(ROI) %
2. Downside Breakeven Protection %
To understand these two terms, we will first describe and show the formulas for how they are calculated. Then we will further clarify ‘how-to’ calculate them by performing the calculations using a specific example (Hewlett Packard).
1. Annualized ROI % - Two percentages are calculated here that are relevant to the covered call selection process:
(a) Annualized Return If Unchanged (ARIU) – more fully described as the annualized return-on-investment % if the stock price is unchanged at expiration compared with its current price. The formula is:
ARIU= ($ option premium/$ original investment)*(365 days/# days until expiration)*100
(b) Annualized Return If Exercised (ARIE) – more fully described as the annualized return-on-investment % if the stock price is above the option strike price at expiration and is therefore exercised (Note: other synonymous terms for ‘exercised’ are ‘assigned’ and ‘called’). This is the best-case scenario wherein the maximum return potential for the covered call position is achieved. The HPQ example below shows that the percentages for ARIU and ARIE are identical for a covered call position that is in-the-money (ITM) when originally established. However, the ARIE percentage will be higher than the ARIU if the stock is out-of-the-money (OTM) when the covered call position is established. In this OTM instance, the formula is:
ARIE = [((option strike price – current stock price + option bid price)/current stock price)*(365 / # days until expiration)]*100
2. Downside Breakeven Protection (DBP) % -- This measure shows what % the current stock price would have to fall by the expiration date to reach a breakeven point (i.e. $0 profit and $0 loss) on the total covered call position. The formula is simply:
DBP=($ option premium/$ stock price)*100
Note: Commissions should normally be included in the calculations above, but are excluded here to make the formulas somewhat easier to understand.
Now we’ll use a specific option chain for Hewlett Packard (HPQ) to show how the calculations are made in a specific circumstance. The pertinent information for the two closest strike prices are:
Hewlett Packard(HPQ) Current Price = $50.42
Oct07 50 Bid Price = $1.65
Oct07 52.5 Bid Price = $.40
Example 1: Sell In-the-Money (ITM) Covered Call:
On 10/3/07: Buy 100 HPQ @ $50.42 = $5,042
Sell to Open (STO) 1 Oct 50 @ $1.65 = $165
ARIU = +52.4% = [($165-($5,042-$5,000))/$5,042]*(365/17 days)
ARIE = +52.4% -- Same as ARIU since ITM
DBP = (1.65/50.42)*100 = 3.3%
Example 2: Sell Out-of-the-Money (OTM) Covered Call:
On 10/3/07: Buy 100 HPQ @ $50.42 = $5,042
Sell to Open (STO) 1 Oct 52.5 @ $.40 = $40
ARIU = +17.0% = ($40/$5,042)*365/17 days)*100
ARIE = +105.5% = ((52.5-50.42+.40)/50.42)*365/17 days)*100
DBP = (.40/50.42)*100 = 0.8%
Notice the inverse relationship between these two key factors – annualized ROI % and downside breakeven protection %. When both factors are considered together, they demonstrate the essence of the risk-reward principle. That is, in order to achieve greater potential reward (17.0% and 105.5% in example #2 above), we need to be willing to accept greater risk (i.e. less downside breakeven protection; only 0.8% in example #2 above). Conversely, we can achieve less risk (for example 3.3% downside breakeven protection in example #1 above) but with less maximum potential reward (+52.4% in example #1 above). Ultimately, each of us covered call investors must find our own personal risk/reward comfort level and make our covered call investment decisions accordingly.
For this covered calls advisor, a minimum threshold of +30.0% ARIU and >.06% per-day DBP is required. Example #1 above exceeds these criteria (52.4% ARIU and .19% (3.3%/17 days) per-day DBP; so this position would be a viable candidate for further analysis as a possible covered call investment (remember, this advisor analyzes eight additional factors before determining whether a particular covered call position is a buy). In Example #2 above, the covered call position does not meet the minimum threshold criteria and therefore would not be given additional consideration. As implied earlier, your thresholds might be different from that of the Covered Calls Advisor since they are dependent on your own personal risk tolerance. If you’re more cautious, then your ARIU minimum would be lower and your DBP threshold higher. Conversely, if you are more risk tolerant you might have a somewhat higher ARIU minimum but with an accompanying DBP threshold even lower than this advisor’s .06% per-day minimum.
These concepts might be somewhat confusing at this moment, but please persevere. If necessary, re-read the article above to gain a better understanding of its contents; or click on the ‘Comment’ link below to provide a specific comment or ask a question.
Regards and Godspeed