Here is a snapshot of the discussion:
- Question: If you opened a credit spread for $1.00 credit and closed it for $0.50, how much did you make in percentage terms?
- Answer: it depends. (Hint: most likely, it's not 50%)
Lets examine two cases, using the same underlying (BABA).
Credit spread
Lets say you decided to sell 130/135 credit spread for $1.00 credit. The P/L chart look like this:
As we can see, the margin requirement is $400 (the difference between the spread width and the credit), the maximum gain is 25% and the maximum loss 100%. Maximum gain is realized if the stocks stays below $130 by expiration and both options expire worthless. maximum loss is realized if the stock is above $135 by expiration and both options are ITM. In this case your loss is the $5 less the $1 credit.
Short Strangle
Now lets see what happens if we try to sell a naked (short) strangle, using 110 puts and 140 calls, for the same credit of $1.00. Here is the P/L chart:
As we can see, the margin jumps to almost $1,250. Maximum dollar gains remains the same ($100), but return on margin is reduced to only 8%. If you sold the strangle for $1.00 and bought it back for $0.75, you made $25, which is around 2% return on margin.
Here is a general guideline how to calculate ROI on credit spreads.
Let say we open a 10 point wide credit spread (i.e. there are 10 points between the sell leg and the buy leg for the credit spread) The broker requires $1000 of maintenance margin to open this credit spread. When we open this credit spread for $2.00 credit, or $200. Our risk capital is then $1000 – $200 = $800. The potential ROI is then $200/$800 = 25%. If you close the trade for $1.00 debit (50% of the maximum gain), your gain is 12.5%, not 50%.
Why it is important you might ask?
Well, lets say you have a $100k account and decide to allocate 10k (or 10%) per trade. If you allocate 10k per trade and make 25%, you would expect to make $2,500, so your account grows by 2.5%, right? Well, in case you sold the naked strangle, you can sell only 8 contracts based on the margin and your allocation. When you buy the 8 contracts back for $0.75, you make $200, which is 2% gain on $10k trade.
If you are still not convinced, here is another way to look at it:
- When you sell a $5 wide credit spread and get $1 credit, you risk $4 to make $1. Your risk/reward is 1:4 - you can lose 100% and make 25%.
- When you sell a $10 wide credit spread and get $1 credit, you risk $9 to make $1. Your risk/reward is 1:9 - you can lose 100% and make 11.1%.
I hope you can see how margin impacts the returns when you are selling options.
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