Expected Return of a Call Option

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The expected return of a call option is based on several factors. Ultimately, the expected return depends on the price of the stock at expiration, but the option premium also plays an important role. The expected return also depends on the investor's ability to accurately forecast price movements in the underlying stock.

Formula

  • The formula for calculating the expected return of a call option is projected stock price minus option strike price minus option premium. Each call option represents 100 shares, so to get the expected return in dollars, multiply the result of this formula by 100. Of course, the calculation does not take commissions into consideration.

    For example, assume ABC stock is trading at 62 and you expect it to go to 70. You look at an option chain for ABC and see that the 62.50 call option is trading for 1.5. In this case, the expected return is 70 minus 62.50 minus 1.5, or 6. In terms of dollars, that equates to $600.

Volatility

  • Volatility affects the expected return of a call option because it alters the premium. Option prices are based on both underlying prices and volatility. High volatility raises option premiums, while low volatility lowers option premiums. Therefore, when possible, buy during times of low volatility to increase the expected return.

Time

  • A portion of option value is based on the amount of time left in the life of the option. This means that the option must have some intrinsic value at expiration or it will gradually become worthless. Therefore, if the option expires without intrinsic value, you lose the entire premium. However, if you sell the option back before expiration, you retain a portion of the premium.

Altering Expected Return

  • One way to alter the expected return is to create an option spread by selling a call option. For example, you expect ABC stock to rise moderately, so you buy a call at 62.50 for 1.5 and sell a call at 67.50 for 0.50. This raises the expected return by 0.5 or $50 if the stock goes to 67.50 or lower, but it also negates any gains above 67.50. Therefore,

    this technique lowers risk, but it may also lower reward.

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