If you are an options trader who is serious about covered call option writing, you should take a look at the covered call calculator on the Montreal Exchange’s Web site (www.me.org). Once there, look for the “trading tools” heading on the right-hand side of the screen and click on “covered call calculator.”
The covered call calculator allows you to search for attractive Canadian covered call positions based on rate-of-return criteria. You can set the search criteria to include a number of items, such as specific stocks, or the entire database of Canadian optionable stocks (see drop-down menu for “underlying issue”).
You also have the ability to set screens, including total “premium” received based on a percentage of the total value of the underlying stock, or total “potential capital gain.” You can then have the results sorted by a variety of criteria, including total potential return, premium, gain or open interest.
According to the ME Web site: “The option premium return is obtained by dividing the option’s premium by the stock’s current price. This result is annualized by multiplying the result by 365 days and dividing [the product] by the number of days until the options expire. To be eligible, an option must have a return higher than the one entered in the ‘premium’ field.”
To cite an example, I set the premium field to 10 (representing 10%) and the potential capital gain field to 10 (meaning I wanted to search for positions with a minimum return including the capital gain that would occur if the stock rose and was called away of 10%), and asked the system to sort the data by the premium. I also asked to look at only covered calls that expired in December or later.
At the top of the list was Western Oil Sands (WTO) December 26 calls that were bid $1.75 a share at a time when the last price for the underlying stock was $25.35. The December 26 calls expire on Dec. 16. In this example, the premium ($1.75) is divided by the share price ($25.35) which equals 6.9% and would be earned over the next 53 days until expiry. That return assumes the underlying stock unchanged over that period. To annualize the 6.9% return over 53 days, we multiply the return by 6.89 (representing 365 days in a year divided by 53 days to expiry = 6.89). That gives us an end value of 47.5%, which exceeds the 10% number used in the search criteria.
The premium field is what investors would use to evaluate a covered call write on the basis that the underlying stock remains unchanged until the options expire.
The other field investors can use is potential capital gain. Says the ME: “The potential capital gain is obtained by subtracting the stock’s market price from the option’s strike price. The result is divided by the market price of the stock. Note that this number can be negative. The data [including the negative number from the initial calculation] are annualized by multiplying the total return by 365 days and dividing by the number of days until the option expires. To be eligible, an option must have a potential gain higher than the one entered in the potential capital gain field.”
The negative number in the potential capital gain field may be misleading. Why enter any covered write with a negative expected return? The idea is to open the door to potential in-the-money covered writes that may be overlooked when using only a positive number in the potential capital gain field.
Consider this example: suppose you were looking to buy Suncor Energy (SU) at $59.45 and sell, say, the SU December 50 call at $10.45. The potential capital gain field takes into account a capital gain resulting from the stock advancing up to the strike price of the option. But there is no capital gain — apart from what is earned by the premium received — if we are dealing with in-the-money calls. In the SU case, if we subtract the stock price ($59.45) from the strike price ($50), we end up with a negative value of -$9.45. The system takes the -$9.45 and divides it by the stock’s market price ($59.45), giving us -15.9% (or -109.4% annualized). If we had input a positive number, this in-the-money covered call write would not pass the grade.
@page_break@But having a negative number based on the calculation does not imply a negative return. That is because the premium received ($10.45 a share) actually reduces the cost of the stock to $49 and your effective sale price would be $50 a share at the December expiration. If the stock were called away, the return is 2.04% over the next 53 days, or 14.04% annualized.
Options with a bid equal to or less than 20¢ will not be displayed in the search results. And transaction costs are not taken into account, which would reduce the total potential return. IE
ME offers covered call writers a useful tool
- By: Richard Croft
- December 5, 2005 October 31, 2019
- 15:18