Ask Mike:
I still don't understand annualized returns as a reason for getting out of a covered call trade?

Question:

Hi Mike,

I still don't understand why you keep emphasizing annualized returns as a reason for getting out of the trade early. Would you please explain this again?

Kate from Portland, OR

Mike's Response:

Hi Kate,

Our first task is to determine if the planned trade is going to generate enough potential return to make the investment worth the risk. I look for trades where a stock has strong fundamentals, strong technicals a near-term expiration date, and either an in-the-money or one-strike out-of-the-money call, that is high enough in price to generate an acceptable level of potential return.

My entry level for this trade is a minimum of 60% return, annualized, if the trade is held through expiration. Here's an example: Let's assume that the time to expiration is 2 months my total net return on the trade is 10%. This means that if the stock moves up in price to the strike price and I am assigned on the expiration date, I will have made 10% in 2 months. Assuming I could make that same 10% every 2 months, at the end of one year, I would have made 6 times 10% or 60%. My annualized return is, therefore, 60%.

Now, lets say that 1 month into the trade, I can buy back the call and sell the stock and net 8%. 8% is significantly less than 10%, so why would I settle for a 20% loss in my potential return of 10%? Let's do the math... Getting out of the trade in 1 month instead of the 2 months originally planned, I will have removed 50% of my risk in the trade. Why? Because I will have closed the trade and put the money in the bank and it will no longer be at risk in the market. Anytime you have money invested in the market, you are risking that the market will not move against you. Closing the trade takes me out of the market and removes 1 full month of risk.

Closing the trade netted me 8% in this example, which is 96%, annualized. So, I have increased my annualized return by more than 50%, AND, I have removed 50% of my risk in the process.

This is why I am continually looking for an early exit strategy for each of my covered call strategies.

Regards,

Mike