Fri Mar 24, 2006: Option Writing Income Calculations for Covered Calls

Today I got another email question about the percentage return calculations for covered calls so I thought I'd post part of my response here.

In future commentaries I'll go over other calculations for all the different strategies.

Here's the equation for covered call writing:

income = (option price - any in-the-money amount) / (stock price - option price)

Let's look at two examples.

Example 1. stock price $12.00 and a $15.00 strike covered call (out-of-money) priced at $2.00

(2 - 0) / (12 - 2) = 2 / 10 = 20% return

Think about what happens when you buy this stock if it stays unchanged.

You will have to pay $1,200 to buy 100 shares but immediately get back $200 from selling the call so your net investment is $1,000. You can withdraw the $200 immediately after the option sale settles so you only need to have $1,000 tied up during the option period, after which you end up fully owning $1,200 of stock.

So that's a 20% profit.

In fact some brokers who allow "buy-writes" require only $1,000 up front, that makes it simpler.

Example 2. stock price $12.00 and a $10.00 strike covered call (in-the-money by 2) priced at $3.00

(3 - 2) / (12 - 3) = 1 / 9 = 11% return

Again let's assume the stock remains unchanged. You pay $1,200 to buy 100 shares and receive $300 income, which you can withdraw immediately. So you have $900 invested.

The stock gets called away at 10 so you end up with $1,000 cash in your account.

That's an 11% profit.

Keep those email questions coming, and please let me know if you have any requests or suggestions for changing or improving the site. Thanks in advance.

Until next time, best of luck with your option investments!