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Posts Tagged ‘calls’

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.

Nucor Trade

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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2 comments - What do you think?  Posted by Cash Flow Mantra - May 22, 2012 at 9:39 am

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