Wednesday, October 10, 2007

Using ONLY Annualized Return on Investment %

Let me state my position on this topic as directly and forcefully as I can: "When evaluating the return on any potential investment (and that definitely includes all potential covered call investments), always calculate the annualized ROI %."
For covered call investments, the formula for calculating the annualized return on investment if the stock price is unchanged at expiration compared with its price when the covered call position was established (annualized return if unchanged; or ARIU) is:
ARIU= ($ option premium/$ original investment)*(365 days/# days until expiration)*100
For example, American Express(AXP) closed today at $61.89. If we purchased 100 shares at $61.89 and sold 1 NOV'07 62.5 call at its bid price of $2.00, the corresponding annualized ROI % calculation (excluding commissions) would be:
ARIU = ($200/$6189)*(365/37)*100 = 31.9%

The importance of always calculating the annualized ROI % cannot be over-emphasized. In short, it is the only way an investment return should be considered in relation to its potential as an investment. In addition to its usefulness in evaluating potential positions, it is also the method by which any investment return result should be measured; both when an existing position is finished as well as for some specified duration of time, such as at the end of each month. Some of you are now thinking 'Yes, of course. Why does he even need to spend the time to emphasize such a fundamental principle?' -- and if you already use this approach, then good for you. However, this advisor has simply seen far to many instances when financial analysts and investors have used other measures (i.e. different than annualized ROI %) to analyze investment returns; and erroneous measures often and readily lead to erroneous conclusions regarding which covered call investment alternative provides the highest return.

Two examples of incorrect, but frequently used approaches by investors in looking at the relative attractiveness of the returns on potential investments are: '$ returns' and '% absolute returns'. Unfortunately, many investors focus on one or both of these measures while totally neglecting the preferred measure of annualized ROI %. The chart below presents these three return measures for evaluating AXP covered call choices for the 62.5 strike price and for four different expiration months (Oct'07, Nov'07, Jan'08, and Apr'08).

In looking at the chart, which of the four expiration months provides the highest return? If you said "October 07", then congratulations!
But let's explore this a little further. As an example, if Investor A is primarily interested simply in $s returned, then the $490 for the Apr'08 covered call seems like the best alternative. If Investor B is somewhat more savvy than Investor A and calculates a ROI %, but calculates simply the absolute ROI % ($ option premium)/$ original investment), then the 7.9% return for the Apr'08 covered call would again seem to be the best choice.

The misguided approach used by both Investor A and Investor B will invariably lead them to the wrong selection if one of their primary objectives is to maximize the return on their investment. The Oct'07 covered call annualized return of 49.1% actually provides the highest return opportunity of the four expiration months analyzed in this example. The essential fact is that always calculating the annualized ROI % is the best method for providing an apples-to-apples comparison of investment alternatives with varying time horizons. I feel fortunate for having gained an appreciation for this approach many years ago from an excellent Engineering Economics professor in a course taken during my sophomore year at N.C. State -- it has benefited me greatly throughout both my professional and investing careers.

So, do you agree that you should always calculate the annualized ROI %?
I know, some of you are now saying "yeah, I agree with that; but a complete analysis of a potential covered call position must consider more than simply which alternative will provide the highest annualized ROI %!"
My response to that is "Yes. Absolutely! But analyzing the potential return on any investment is critically important (Job #1 so to speak); so using the correct analytical approach is key."
You might add: "What about investing safety, such as how much downside protection I should obtain? And don't the longer-term expirations usually provide more downside protection?"
My answer to that would be "sometimes yes and sometimes no".
But that's a topic for a later date.

Regards and Godspeed