Members:

We get emails from time to time asking how we calculate our % returns. We realize that there is more than one way to calculate the return. We have chosen to use the method that most authors use in their books, since most of you will be familiar with this calculation. However, for simplicity we do not consider margin, dividends or commissions. The formulas we use are as follows:

Out-Of-The Money

If not called and stock price remains unchanged:

premium / (stock price - premium)

If called:

(premium + gain on stock) / (stock price - premium)

In-The Money

Return = profit / out of pocket cost

Where: profit = strike price - out of pocket cost
Where: out of pocket cost = stock price - premium

Again, the foregoing is the calculation that you will find most authors using in their books, including McMillan (see pages 39-41 of "Options As A Strategic Investment"), without consideration for dividends and commissions.

Puts:

There are differences of opinion on how to calculate returns for naked put writing. For simplicity, we use the calculation set forth below. The main purpose is to give you a number to compare against other possible put writes.

return = premium received / (50% of strike price)
(assumes that the stock price stays above the strike price and that the option therefore expires worthless)

Credit Spreads:

Return = credit / (# of contracts times the strike spread) - credit
Example: A spread play provides a credit of 75 cents. On 10 contracts; that's $750. A typical account hold required by brokers is the number of contracts (10) times the strike spread (assume $5 spread) which equals $5000. With the credit of $750 the actual hold in your account is $5000 - $750 = $4250. Thus, the return in this example is 750/4250 = 17.65%

Remember, whatever formula you decide to use, use it consistently so that you are comparing different possible plays against a constant formula.

Sincerely,

Eric J. Aafedt
CoveredCall.Com, Founder
Online Investment Services, LP., President