Ask Mike:
Why do you keep mentioning annualized returns?

Question:

Hi Mike,

I like the returns I have been getting following your trades. Thank you!

I have a question. Why do you mention annualized returns? I would think just showing the real net return would be more than good enough, especially since it has been so good.

Thank you,

Joan from Scottsdale, NV

Mike's Response:

Hi Joan,

Knowing your annualized return on each trade is extremely important. Here is why...

Let's say you made 10% on two separate trades.

With the first trade, you held the stock for 12 months and then sold it for a 10% net gain. With this trade, your annualized return is 10%.

With the second trade, you held the stock for 6 months and then sold it for a 10% net gain. With this trade, your annualized return is 20%.

With your first trade, you had your investment at risk for 12 months in order to gain the 10%. In the other trade, your money was at risk for only half that amount of time, to get the same return. Plus, in the second trade, your money was freed up to invest for another 6 months. So you got twice the usage value of your investable cash, giving you more opportunities to make more profits.

In my Stock and Option model portfolio, we have a covered call strategy in place that is tied to a calendar. The objective is to make at least 60% on an annualized basis by making enough of a net profit between the start of the trade and the Expiration date of the contract. We buy a stock and sell a call against that stock. With a covered call, we make money if the price of the stock goes down, goes up or stays flat and doesn't move. Whereas, if you are just buying a stock and holding it until it moves up in price to sell it, you can only make money one way... only if the stock moves up in price. With a covered call trade, you get money from the sale of the call and, generally, when you sell the stock, hopefully at the strike price. You even make money if the price of the stock goes down, as long as it doesn't lose more than you made on the sale of the call.

But, there is another important concept with covered calls... And, that is to measure how quickly you made a profit. The quicker you can make a profit, the less time the stock has to move against you. This lowers your risk of a loss. Plus, the quicker you can make a profit, the quicker you will have your money back to reinvest.

There is a fine line and a significant line between just churning trades and minimizing risk exposure. You will see in this week's newsletter that I have introduced an enhanced strategy to my Stock and Option portfolio that weighs time and potential gain from closing out a position.

I look at the maximum annualized gain if the stock is held to Expiration and then assigned at the Strike price. This is the maximum gain that can be derived if everything goes according to plan with the stock moving up above the Strike price and stays there through the Expiration date.

Then, I do a calculation to determine what my annualized gain would be if I bought back the calls and sold the stock. As soon as this return gets to be significantly higher than the theoretically best return I can get by holding through Expiration, I will close out the trade. I use a sliding scale based on the number of weeks left before Expiration. The further out, the more this return should be, so that I don't close out too soon and leave too much money on the table. With a month or more before Expiration, I like to be 300% or more. When I can get that return, I prefer to close out the trade early and then reinvest that money again the following week.

So... Joan, I use annualized returns as an important component of my investment strategy.

Thanks for the question!

Mike