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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.


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