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

  • Expiration Short Strategies

    Some traders have entered the options arena by selling exceptionally long-term contracts. The rationale for this is based on dollar amounts. A 24-month contract may yield an impressive dollar amount, but is it the best net return? It is not.

    By Michael C. Thomsett,

    • 0 comments
    • 128 views
  • Should You Finance or Pay Cash for a Home?

    When buying a home, individuals who have accumulated enough wealth to pay cash or make a substantial down payment have a decision to make. Take advantage of record low interest rates and lock in a 30-year mortgage for around 2.5%? Or pay cash and make payments to yourself by investing the savings?

    By Jesse,

    • 0 comments
    • 135 views
  • Implied Volatility Collapse

    The key ingredient on expiration Friday is volatility collapse. At the beginning of that last trading day, there are more than 6 hours of trading yet to go. However, there are 38 hours left before expiration on Saturday. When volatility is high, OTM options are most likely to be overpriced.

    By Michael C. Thomsett,

    • 0 comments
    • 233 views
  • Trading Volatility: Why It Isn’t Always a Bad Thing

    Volatility is still widely misunderstood — and feared — by novice traders. As someone lacking in trading knowledge and experience, you often hear and believe horror stories of unstable markets. The fear is valid. After all, your shares and investments are at an elevated risk in an unpredictable environment.

    By Kim,

    • 0 comments
    • 208 views
  • Models and their limits

    Options traders tend to think mathematically. When considering selection of an underlying, risks and expected profits, the model of outcomes is a primary tool for making selections. Without a model how can anyone understand the differences between two or more options that might otherwise appear the same – similar moneyness, same strike, and same premium.

    By Michael C. Thomsett,

    • 0 comments
    • 212 views
  • When You've Only Got $1000 To Invest, What Do You Do?

    Are you new to the world of investments? Most likely; it’s not something you just fall into! BUt at the same time, investing can be done by anyone. Investing doesn’t need to be saved for retirement. It isn’t something only the uber rich are able to get into.

    By Kim,

    • 0 comments
    • 454 views
  • Use of Options Spreads to Reduce Risk

    Traders may view spreads as a means for reducing market risk. But this also means that the potential profit is just as limited as potential loss, and this is easily overlooked in the focus on risk alone. A realistic view of spreading is that it reduces risk in exchange for accepting limited maximum profit.

    By Michael C. Thomsett,

    • 0 comments
    • 524 views
  • Put Writing in 2020: The Role of Timing Luck

    The impact of luck can play a meaningful role in the short-term outcomes of monthly option trades due to the requirement to roll expiring contracts. The extreme volatility in 2020 highlightsthis fact when we look at results of SPY cash secured put trades launched on slightly different start dates.

    By Jesse,

    • 0 comments
    • 507 views
  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 682 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 573 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido