For example, for a covered call, do you divide profits by your original cost per share, by current value, or by the call’s strike?
Original cost per share is not useful for the calculation. In some outcomes, this price per share will be significantly power than current price. The current value is also not useful, as it changes constantly and does not reflect a true outcome. Only the strike of the covered call can be used to consistently compare one outcome to another.
The initial calculation is easy enough,. Divide net income by the strike. For example, you sold a call for 6 and recently bought to close at 2.50. Your net profit was 3.50 ($350). The strike in this case was 125, and the call was open for 72 days. Initial net return:
3.50 ÷ 125 = 2.8%
Because the position was open for 72 days, the initial return has to be divided by that holding period and then multiplied by the full year:
2.8% ÷ 72 days * 365 days = 14.2%
The annualized yield was 14.2%. In other words, the same outcome, if held for exactly one year, would have been 14.2%, not 2.8%. This becomes important when yields are compared with different holding periods.
Looking at another example: you sold a call for 6 and recently bought to close at 2.50. Your net profit was 3.50 ($350), the same numbers as in the first example. The strike was 125, but this option was over for 183 days. Now the annualization of profits looks significantly different:
3.50 ÷ 125 = 2.8%
2.8% ÷183 days * 365 days = 5.6%
Now, instead of double-digit return of 14.2% as in the first example, in this case annualized return was only 5.6%. The sold reason was the holding period. Even though the buy and sell levels were the same, and the strike was 125 in both cases, there is a substantial difference between 72 days and 183 days.
Applied to a series of trades with similar initial returns, but different holding periods, a big difference is realized upon annualizing. We have all heard of traders boasting about 125% returns, but they don’t always tell you it took three years, so annualized this is less than 42% -- still not bad, but not the same as 125%.
Annualizing just makes sense in order to ensure accurate comparisons between trades. The accurate calculation of annualized yield is even more complex when dividends are taken into consideration. Combining option profits with dividend yield produces an outcome called total return, but quarterly payments fall in different way.as For example, over 72 days, you could earn two quarterly dividends covering about 60 days; or you could earn three quarterly dividend s(on days 4, 34, and 64, for example).
To include dividend yield accurately, first calculate annualized return for the option profits only. Then add in the dividend based on the number of ex-dividend dates occurring during the time the covered call was open.
Dividend yield is easy to calculate. It is the yield based on the price paid per share at the time of purchase. As long as the company’s dividend per share is the same, the yield will also be the same no matter how much the underlying price changes.
If dividend per share is changed during the time the covered call is open, the effective yield on the day before ex-dividend date should be used to calculate accurate dividend yield and total return. Chances are the change during a holding period is not going to make a lot of difference, but for complete accuracy, this has to be taken into account.
The annualized option return is then added to actual dividend yield. This yield does not have to be annualized because it is paid (and earned) on a quarterly basis. This complicates the whole process of annualization, but promotes accuracy and consistency when working with several different trades during the year.