SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Calculating ROI on Credit Spreads


The trigger to this article was a discussion I had with someone on Reddit. There is a common misconception about calculating gains on trades that require margin, like credit spreads and short options (naked puts/calls, strangles or straddles). I believe it is important to explain how to do it properly.

Here is a snapshot of the discussion:

Capture.PNG

 

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:

strangle.PNG

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:

Capture.PNG

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.


Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Investing in Private Companies

    It is axiomatic that the largest investment returns typically come from investing in private companies. Peter Thiel initially invested $500,000.00 in Facebook, which was worth over $1b when he cashed out.  Eric Lefkofsky turned an investment of $546 (that’s not a typo) into $386m in cashed out payments.

    By cwelsh,

    • 0 comments
    • 68 views
  • Option Strikes and Expirations – What's Next?

    Options expiration dates and strikes are among the most important parameters options traders must consider. Today we have the well-known weekly, monthly, cyclical, and LEAPS options. A lot of choices. But is that as far as we can go? The realm of possibilities could be endless. Consider some of these possible expansions:

    By Michael C. Thomsett,

    • 0 comments
    • 163 views
  • Buying Deep Out-Of-The-Money (DOTM) Options

    “Income” trading has become wildly popular for option traders since the global financial crisis. This style involves selling out-of-the-money options to a hedger and collecting the full premium payment at expiry — assuming the underlying doesn’t trend too hard in one direction.

    By Tyler Kling,

    • 0 comments
    • 456 views
  • The ABCs of QE And QT

    Is QE money printing or is it something else that appears to be money printing? Search the internet for “QE and money printing”, and you will see countless articles explaining why Quantitative Easing (QE) is or is not money printing. Here are a few articles that we found:

    By Michael Lebowitz,

    • 0 comments
    • 137 views
  • A Case Study in SPX Put Writing

    I've written about writing puts on multiple occasions, as I find it to be an attractive way to gain long exposure to the underlying asset class. It doesn't have to be a decision of one vs. the other (meaning, is it better to sell puts or own the underlying asset directly?), as there are advantages and disadvantages to both.

    By Jesse,

    • 0 comments
    • 236 views
  • 10 Tips: Trade Options Like a Pro and Keep Your Day Job

    Do you feel you don't have time to trade options?  This is one of the most common objections I hear from potential traders. In this article I'll give you 10 actionable tips to trade options like a pro while you balance life's other commitments.

    By Drew Hilleshiem,

    • 0 comments
    • 592 views
  • Straddles - Risks Determine When They Are Best Used

    Risk all too often is defined by the attributes of a strategy, and nothing more. However, the circumstances under which a position is opened is a better indicator of actual risk. Why? Because risk is not fixed but varies based on proximity of price to strike, and of strike to resistance or support.

    By Michael C. Thomsett,

    • 0 comments
    • 359 views
  • 4 Directional Options Trading Strategies

    Some Option traders prefer to trade mostly non directional strategies, while other option traders prefer to trade directional strategies.  Well, in the world of Options trading, there is no right or wrong answer. You can create a host of strategies based on your preferences and outlook.

    By Kim,

    • 0 comments
    • 510 views
  • Digging Deeper into the Inflation Threat

    Stoking the Embers of Inflation is one of the more important articles we have written. The Monetary Equation Identity discussed in the article provides a counterintuitive way to think about inflation. It took us a long time to accept that this identity lays out a real case for stagflation.

    By Michael Lebowitz,

    • 3 comments
    • 1,189 views
  • Does Option Selling Have Positive Expected Returns?

    Academic research refers to the persistent phenomenon of ex-post implied volatility (IV) exceeding realized volatility (HV) as the Volatility Risk Premium (VRP). As it applies to option premiums, this leads to a positive expected return for being a systematic option seller.

    By Jesse,

    • 0 comments
    • 659 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs