On a realistic level, your calculations of returns on option trades should be possible with a desk calculator; it should be quick and easy; and the results should tell you all that you need to know immediately.
For all long positions, the basic calculations are very straightforward. To review, there are various terms used to describe an outcome, including “return on investment,” “yield,” and numerous other wording. The expression net return is useful because it is simple, but it qualifies the return. By “net,” this expression means actual dollar values realized and expressed as a percentage.
So transaction costs are deducted from both the buy and sell sides of the transaction, and the return is calculated based on dollars-in and dollars-out results, or the “net.”
The Safety Net: You purchase a call for 0.75 ($75) and also pay a brokerage fee of $12.50. Your basis in the long position is $87.50. Two months later, you sell for 1.5 ($150). Your brokerage firm deducts another $12.50 from proceeds and credits your account with $137.50. To calculate net return, first calculate the net profit:
Next, divide the net profit by the original net basis:
If you also want to annualize this return (to compare it to other long positions), you divide the percentage by the holding period (2 months) and multiply by 12 months:
As with all other instances of annualizing returns, this should not be used to set a standard for outcomes in future long positions. It is useful only for comparisons between similar risk levels of trades.
The long position calculation is simple compared to calculations for short positions. In the short position, you sell first and realize a profit when one of three events occurs: (1) the position is closed when you enter a buy; (2) the option is exercised; or (3) the option expires worthless.
Calculating net return for long positions is simple because the levels of risk, capital requirements, and outcomes are well understood. The same argument is not true for short position net returns.
Short-position calculations for calls are complicated by three factors:
If you own stock and sell covered calls, you can perform one type of net return calculation separate and apart from the value or profit on stock. Assuming your purpose in selling the calls is to increase current income and not to force exercise, you may consider only call premium and calculate the return in one of four ways:
Upside-Down Return: You sold a covered call four months ago and received a premium of 5 ($500). Net proceeds came to $487.50. Last week, you entered a buy to close order at 2 ($200). Net cost was $212.50. Your net return considering only the option transaction was $275 ($487.50 – $212.50). That was 129.4 percent based on the closing buy price. This is a somewhat unrealistic form of return, because the transaction occurs in reverse. You cannot, however, calculate the return based on the initial sales price of the option. This format may be useful for comparative purposes, but it does not give you a full view of how net return worked in this example.
A Striking Proposal: You may base potential profit or loss on the striking price of the option, regardless of your actual basis in the stock. You own 100 shares of stock you originally purchased at $32 per share. Today, the stock’s value is at $42.50. You want to write a covered call and you have reviewed both 40 and 45 striking prices. The 40 call provides higher premium, but the 45 is also attractive and out of the money. So you calculate the total net return including dividends you will earn between now and expiration date; capital gain or loss (based on current value rather than original price), and the option premium.
Your Basic Basis: Given the same facts as in the previous example, you may consider striking prices of 40 and 45, given the current value of stock at $42.50. However, in making the comparison, you use your original cost per share of $32. This enables you to judge the relative value of one option over the other in deciding whether to write the covered call.
Both situations are somewhat distorted because option profit or loss is combined with the stock capital gain. However, net returns aside, it is clear that the comparison has to be made in order to judge the viability of one striking price over the other.
Separate but Equal: You are considering writing a covered call on stock you originally bought at $28 per share. Today, you can write calls with striking prices of 25 or 30, and both are attractively priced. However, in a separate analysis of each, you abandon the 25 striking price because, if exercised, that would create a capital loss in the stock of three points. The 25 call is available for 4.50 today. The combined income from stock and option would only be $150, whereas exercise of the 30 call would include three points of capital gain in the stock plus two points in the option. You calculate the potential profit or loss separately, but you use the comparison to eliminate the in-the-money call.
The same approach can be used when you buy or sell options or when you write covered calls. You might have only half the stock’s value on deposit with the balance on margin; you may also be required to leave only a portion of an option’s value in your account in order to open an option position. The calculation of net return, in this case, is not going to be based on the movement of a number of points, but rather on the change in your actual cash position. It requires that you add together the stock capital gains, option profits, and dividend income, and deduct any losses as well as transaction and interest charged by your brokerage firm. The net income is not based on the prices of stock and option but on the amount of cash you had on deposit.
When you base net return calculations on cash actually at risk, you have two variables. First is the higher risk of trading on margin, and second is the greater potential gained from leverage. These are two aspects of the same advantage/problem.
The leveraged approach will produce much higher percentage gains, but it also involves greater risk. When you suffer net losses, you will be required to make up the difference in cash. For example, if you have $2,500 at risk on a $50 stock and it falls five points (10 percent), you will lose $500, or 20 percent of your cash on deposit. The same doubling effect applies to options as well. For example, if you deposit $200 to buy an option priced at 4 ($400) and it expires worthless, you not only lose your $200 on deposit; you also have to pay your brokerage firm another $200 plus transaction fees and interest. In that example, your net loss will exceed 100 percent.