Calculating Return on Investment when Selling Options
Courtesy of Paul Price of Market Shadows
The proper method for determining the return on investment (ROI) when selling (writing) options is a matter of disagreement.
When we sell option contracts, our brokerage account gets credited the net price of the options. In exchange for the proceeds, we obligate ourselves to buy a stock at a certain price (puts) or sell stock at a certain price (calls) on future date (expiration).
Our initial cash ‘investment’ is a negative number.
Figuring ROI on a negative cash outlay is akin to dividing a number by zero. There is no real calculable result.
Here’s an example using a covered call:
1. We hold 100 XYZ shares in a margin type account with XYZ trading for $20 per share.
2. We sell a Jan. 18, 2014 call with a strike price of $22.50 for $1.25 per share minus a $1 commission.
3. Our account is credited with $1.24 per share, or $124 per option contract (100 shares of stock).
If the call expires worthless (XYZ closes below $22.50 at expiration) what was the ROI for the five month holding period?
There are two common methods for calculating ROI in this situation. In the first one, we use the value of our 100 shares of XYZ at $20 (i.e. $2,000) in the denominator of the equation. Using the second method, we use ZERO as the denominator because there was no actual cash outlay for the sold call in this trade.
Using $2,000 as the "investment", we earn 6.2% in 5 months (about 15% annualized). Using $0 as the initial "investment", we do not get a meaningful ROI result.
Another view is that we captured 100% of the $124 potential gain once the option had expired worthless.
It doesn’t really matter which method is "correct." If the call expires worthless, we keep the $124 as profit.
Now assume we sell one Jan. 18, 2014 $17.50 naked put for $1.25 less a $1 commission. $124 gets credited to our account. If XYZ remains above $17.50 through expiration date, the put expires worthless and we keep the $124.
Here are two ways of calculating the ROI:
Both these ROI calculations are correct depending on your point of view.
Sellers of covered calls and/or naked puts in our examples would have pocketed $124 per contract from start to finish on negative initial cash outlays. That is the bottom line.
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Note: Calculating ROI when buying options is straightforward.
Simply divide the final profit or loss by the initial cash outlay. Then annualize it.
Example: Buy to Open (BTO) 1 Jan. $22.5 call for $125 plus a $1 commission. $126 is the initial cash outlay.
137.3% achieved in 5 months = 330% annualized. With intermittent reinforcement, as with slot machines and lottery games, occasional windfalls keep people hooked on playing the game.
Disclosure: I am a regular seller of options, I rarely buy them.
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