THE YIELD DEBATE – PART I
By Michael Craig
I often receive questions from subscribers concerning the yield calculation on covered calls. Furthermore, we have had many hours of debate in our office as to the “right” way to calculate yield. In the resource materials I have read on covered calls, I have seen two different methods listed. WinningInvestments.com uses the more conservative method for calculating yield, but there is another way to accurately calculate your yield.
The main difference between the two correct yield calculations is how the premium is used. If an investor is using the premium to help “purchase” the stock, then a more Aggressive formula can be used. However, if the premium is not used to purchase the stock, then the formula that is used by WinningInvestments.com is the correct formula.
This can be a very confusing concept, but when it is understood, you will have more knowledge on this subject than many who have actually written about it. To keep things simple will name each formula. The formula currently used by WinningInvestments.com will be called the “Standard” formula, and the formula using your premium to purchase the stock will be called the “Aggressive” formula.
First, lets take a look at the “Standard” formula. We are only going to focus on the “Yield if Called,” since there is no real return until the transaction is complete. The “Standard” formula for yield if called is (OPTION PREMIUM + GAIN ON STOCK) / (ORIGINAL STOCK PRICE).
For example:
1. You purchased 1000 shares of ABC Corp. at $48 a share and sold a $50 call for $4.
2. You now own $48,000 in stock, and have a cash balance of $4,000 (1000 shares x $4).
3. Your basis (breakeven point) is now $44 ($48-$4).
4. You are called out on the strike day and sell the stock for $50.
5. Your dollar gain is $6 ($50-$44) per share, or $6,000 ($6x1000 shares).
6. Your percentage gain on the transaction is 12.5% (($4,000 + $2,000)/$48,000), or $6,000/$48,000. $4,000 is your premium, $2,000 is your gain on the stock, and $48,000 is the original stock price.
7. Your account is now worth $54,000 ($6,000 + $48,000), which is 12.5% more than when you started.
Anyway you look at this transaction you have made $6,000. For more information on the “Standard” formula used by WinningInvestments.com, please visit the Covered Calls 101 section of the website or click http://www.winninginvestments.com/ViewArticle.asp?Article=1&Page=9.
Now lets take a look at the “Aggressive” formula. The “Aggressive” formula for “Yield if Called” is (OPTION PREMIUM + GAIN ON STOCK) / (ORIGINAL STOCK PRICE - PREMIUM).
In the following example, you only have $44,000 in your account, as opposed to $48,000 in the previous example:
1. You purchased 1000 shares of ABC Corp. at $48 a share, but since you only had $44,000 in your account, and you bought $48,000 worth of stock, your account has a negative cash balance of $4,000.
2. You sold a $50 call for $4. This sale now “deposits” $4,000 into your account. Your cash balance is now $0.
3. Your basis (breakeven point) is now $44 ($48-$4).
4. You are called out on the strike day and sell the stock for $50.
5. Your dollar gain is $6 ($50-$44) per share or $6,000 ($6x1000 shares).
6. Your percentage gain on the transaction is 13.63% (($4,000 + $2,000)/$44,000), or $6,000/$44,000. $4,000 is your premium, $2,000 is your gain on the stock, and $44,000 is original stock price minus the premium.
7. Your account is now worth $50,000 ($6,000 + $44,000), which is 13.63% more than when you started.
Once again, this can be a difficult concept to initially understand. The main point you need to understand is how the premium is used to buy the stock in the “Aggressive” example.
The differences and similarities between using these two formulas will be discussed in Part II.
Thi
