The proper method for determining the return on investment (ROI) when selling (writing) options is a matter of dispute.
When selling option contracts, we get paid. Our brokerage account gets credited the net price of the options. Those proceeds are in exchange for an obligation to potentially either buy a stock at a certain price (puts) or sell stock at a certain price (calls) through a set future expiration date.
ROI on option short sales is a hotly debated issue.
When selling, the initial cash ‘investment? is a negative number. Cash balances increase by the premium received from the sale the next business.
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. We hold 100 XYZ shares in a margin type account with XYZ trading for $20 per share. We sell a Jan. 18, 2014 call with a strike price of $22.50 for $1.25 per share minus a $1 commission.
Our account is credited with $1.24 per share, or $124 per contract.
If the call expires worthless (XYZ closes below $22.50 at expiration) what was the ROI for the five month holding period?
Here are two alternative ways of calculating ROI. In the first one, we use the value of 100 shares of XYZ at $20 in the denominator of the equation. Using the second method, the denominator is ZERO reflecting that there was no actual cash outlay for this trade.
6.2% achieved in 5 months is equivalent to about 15% annualized.
Yet another potential way of thinking is to say that we captured 100% of the $124 potential gain once the option had expired worthless.
Which view of the possible ROIs is correct? It really doesn?t matter. If the call option expires worthless we have made $124 net dollars.
Whichever percentage gain we choose to accept is correct.
Now assume we sold one Jan. 18, 2014 $17.50 naked put for $1.25 less a $1 commission. $124 would be credited to our account. If XYZ remains above $17.50 through expiration date the put will expire worthless.
Here are two different ways of calculating the ROI:
7.08% in 5 months translates to about 17% annualized. 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.
The sale of 10 contracts would have brought in $1,240 regardless of how you figure your ROI. That is the bottom line.
****************************************************************************** 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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