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## Calculating ROI When Selling Covered Calls

There has been a lot of option activity in my retirement accounts recently so I wanted to take some time and explain how to calculate the return on investment (ROI) using a real example of a trade that I did yesterday.  As you know, I am working on increasing the exposure that my portfolio has to dividend paying stocks.  Well, one of the stocks that I was looking at was Nucor (NUE).  I was able to purchase some shares using the proceeds that resulted from the exercise of ONXX \$46 puts last week.

My goal is to get a 1% return per month on my retirement account on average.  Part of this should come from the increased focus on dividends while the rest will come from capital gains and covered call premiums.  I believe that this is an achievable goal on average, although there will be times when the value will fluctuate above or below that target.

So, here is what I did yesterday.  I started by purchasing the June \$32 strike put options for \$0.49 per share.  Then I picked up the stock itself for \$34.70 and put in an order to sell the June \$35 strike calls at \$1.10.  This was about 5 cents above the ask at the time, but I figured that given the normal daily volatility, it would get filled if NUE approached \$34.90.  This did occur so at the end of the day, this is what my basis looked like before commissions:

\$34.70 for the stock + \$0.49 for the puts – \$1.10 for the calls = \$34.09

So, \$34.09 per share is the amount that I have in the stock.  Now commissions can have a big impact upon return, and I always hate it when those aren’t figured into the equation.  I keep an Excel spreadsheet and add them in automatically based upon cash in and cash of the account.  When I add in commissions for trading, my basis becomes \$34.15322 (\$34.16) per share.  This is the number I will use for the calculations, but it is a little cleaner to look at the numbers without when you are learning.

Return on Investment If Called

If NUE is at or above \$35 per share on June 16, 2012, it will get called away.  If that is the case, let’s calculate the ROI for these four weeks.  The general formula is the amount of profit divided by the amount invested (basis) multiplied by 100 to express in a percentage and would look like this:

(\$35.00 – \$34.16) (profit)/ \$34.16 (amount invested) * 100 = 2.459%

This meets my criteria of gaining 1% in a month.  But what if the stock does not increase and does not get called out?

ROI if Not Called

This is a little more difficult situation to calculate because you really don’t know if there will ultimately be any profit.  This is where the 1% monthly criteria comes into play for me.  I want the premium income itself to equal 1% of the basis.  So in this case, I use the amount of price reduction of the stock price for my “profit” and the basis as the amount invested to make the equation look like this:

\$34.70 (purchase price) – \$34.16/ \$34.16 * 100 = 1.58%

The Nucor trade meets my criteria for 1% monthly.

Capital Losses

Now what happens if the stock drops like a rock.  Obviously, these percentages mean nothing.  But this is where tracking a basis over time becomes useful.  Ultimately, if the stock drops below \$32 rapidly, I will not be in any additional danger of loss since I own the put options.  I can add additional shares to the position each time meeting the above criteria.  Eventually, the stock will stabilize and the ‘ROI if called’ will get realized.

By managing the position and adding shares at lower prices, it is possible to not lose money on a declining stock and break even.

So, if one-third of my stock picks fall into each category, the overall net impact is that the 1% monthly target will be met on a portfolio wide basis.  The fact that I am starting to work with dividend stocks should help to minimize the volatility.  That is the goal anyway.

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It is impossible to know what kind of reaction an earnings report will get and such was the case yesterday with Seagate Technology (STX) when they reported earnings after the close of the market.  It is still unclear exactly what will transpire as a result of this information since the market hasn’t opened today.

But regardless of what happens, I always want to be prepared and able to make adjustments whether the stock decides to go up, down, or sideways.

Seagate Gets My Attention

Seagate initially got my attention in November of last year as a stock that was paying a decent dividend of over 4%.  I thought it would be an important component to my dividend plan for my retirement account.  Ultimately, being able to manage a portfolio of dividend stocks will be some great knowledge to have so that I don’t have to deplete principal during retirement and can live off the generated income instead.

When I purchased STX, I was able to buy it for under \$18 per share.  Since then, I have more than doubled my position and sold calls and purchased puts so that my current basis for the entire position in STX is \$23.41 as of this moment.  Because the stock took a major hit earlier this month, I was concerned about the earnings report.  So yesterday, I purchased the May \$25 puts for \$0.68 per share.

Because I also wanted to benefit from a possible positive reaction especially with the DOW over 13,000 again, I bought back the April \$26 calls that I had sold leading to the current net basis.  Now I still have many April \$28 calls and May \$28 calls outstanding so those April calls could easily get exercised this week if the strength continues.  But I could still buy back the stock next week to get the \$0.25 dividend.

Guaranteed Profit

The best thing about this entire series of transactions is that, no matter what, I have a guaranteed profit of \$1.59 in May even if the stock drops to \$10 per share.  The protective puts assure me of that.  It still works out to a return of \$1.59/\$23.41 = 6.79% for 6 months worth of time.  Certainly not a bad return at all.  Plus I have the previous dividends which I don’t count in the basis at all.

Should I end up selling all the shares at \$28 in April and May, the return would jump to \$4.59/\$23.41 = 19.6%!  It would actually be even better because I still have a few calls that I could sell between now and then to lower the basis a bit more.

But You Missed Out!

Now some of you might be thinking that I missed out on a big time gain if the stock went from sub-\$18 to over \$28.  And you would be right.  But how did I know in November that it would happen like this.  I didn’t!  And anybody who says otherwise is a liar!

Because I don’t know which way the market will go after purchasing a stock, I want to avoid big losses rather than hit home runs.  I know that in the long run I will be better off.

Maybe someday I will explain how I purchased GME at \$25.82, sold it at \$24 and made over 4% annualized profit.  But that’s a subject for another post or even an ebook.

In the meantime, I will be curious to see what happens with STX over the next several days and weeks.

## Options Expire Today (Actually Tomorrow)

It is the third Friday of the month again which, for all practical purposes, means that today is options expiration!  They actually expire tomorrow but since the market isn’t open tomorrow, today is the last day for trading with all the contracts getting exercised or expiring worthless on Saturday.  Because it is expiration Friday, I need to spend part of the early afternoon looking over my positions and figuring out what I want to do for next month.

If you have spent any time at all reading this blog, you know that I hold individual stocks in my retirement accounts and use protective puts to help prevent major losses.  This is a good strategy with one significant drawback.  Puts cost money.  If all I did was to pay out money each month on a stock that was moving sideways, I could easily lose quite a bit of any profits that I would make.

So, in order to offset the cost of the protective puts, I will sell covered calls against those same stocks that I own creating a collar.  Now I may do this for all the shares or only some of the shares in order to capture some capital gains.  It really depends on my optimism regarding the stock which boils down to a gut feeling.  Lately, I have been inclined to remain a little on the cautious side.  The stock market has rallied quite a bit over the past few months, so I am concerned that it might be due for a correction or at least some consolidation.  But who really knows?  I don’t which way the market is going so I try to at least get some benefit no matter what happens.

Action for Today

So the trades that I will be looking for today will be to purchase puts on Seadrill (SDRL), Silver-Wheaton (SLW), Onyx Pharmaceuticals (ONXX), Dryships (DRYS), and Intel (INTC).  I also own AKS but the position is so small I haven’t worried about buying puts.  I am wanting to get out of the stock and into Nucor which pays a higher dividend.  I also own Seagate (STX) but purchased some March puts a few weeks ago after the big earnings spike locking in some nice positive gains.  My basis is \$20.86 per share and the puts are for \$25 so no matter what happens, I will get a gain of over 25% guaranteed in only 4 months.  I like trading when that happens.

Now I don’t want to spend too much buying the puts since I will have to sell some covered calls as well to pay for them.  I won’t be able to with SDRL since I have already sold March calls.  I will likely go with deep out-of-the money puts to protect me only from catastrophe.  With SLW, I will keep the puts a little closer to the actual market price.  The stock is volatile so I want the protection.  ONXX will end up being closer since it has been trending downward.  DRYS will be the 2.5 strike, and Intel will likely be a little farther away.  I sold some calls today that were in-the-money since it seems like INTC has been range trading for the past few weeks.  I am concerned that the market will be declining so INTC may go with it.

This is what my day will hold as far as stock market action is concerned.  I have the day off, so will likely go to lunch at Chuck E. Cheese with my two youngest kids today.  It is a nice treat that we like to enjoy every couple months.  I might have to buy these puts before we go so I am not concerned with the time.

Have a great day, and enjoy the weekend.  I will be doing some writing, hopefully.

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