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

  • Signs that you Are Ready to Start Investing

    If you want to build your wealth, you have to make sure that you invest your money. If you put money into a savings account and don’t earn any interest from it, this won’t work for you in the long term. Your money will lose value because of inflation, and this is the last thing that you need. So when do you invest?

    By Kim,

    • 0 comments
    • 31 views
  • One Year of Diversified leveraged Anchor

    I almost hate to keep saying it, but the Diversified Leveraged Anchor strategy keeps exceeding expectations and performing as designed. To remind our readers, Diversified Leveraged Anchor was created in April 2020 attempting to further increase performance, reduce risk, and to reduce volatility. 

    By cwelsh,

    • 3 comments
    • 428 views
  • Should I Pay Off My Mortgage Early Or Invest?

    Paying off a home mortgage early is a popular financial goal. Most people feel a level financial peace when their home is paid off that is beneficial in many ways. The most common approach to paying off the mortgage early is directly making additional principal payments to the lender on a regular basis.

    By Jesse,

    • 0 comments
    • 120 views
  • Option Order Execution Tips

    As a community of option traders, we all can relate to the occasional challenges of order execution. Best practices for avoiding errors as well as techniques for better potential execution will be the focus of this article.  Like countless others in the Steady Options community, I personally have traded thousands of option contracts over the last decade.

    By Jesse,

    • 10 comments
    • 909 views
  • What Trading Can Offer To A Newcomer

    For any first-time investor, one of the most important questions to ask is “why are you doing this?”. Getting into investment can be thrilling and open up new worlds for you, but it can also be draining both physically and emotionally, with long days and sudden market moves always a genuine risk.

    By Kim,

    • 0 comments
    • 207 views
  • Updated: The Performance Gap Between Large Growth and Small Value Stocks

    Eight months ago on July 21st 2020 I posted an article, The Performance Gap Between Large Growth and Small Value Stocks. Over the long-term small cap value stocks have outperformed large cap growth stocks, although not over more recent history.

    By Jesse,

    • 0 comments
    • 398 views
  • 6 Ways to Invest Your Money That Aren't Cash Savings

    It’s always a good idea to keep some of your money in cash so if there is an emergency and you need money in a hurry, you can access it without having to worry. However, cash savings are not your only option if you have money left over at the end of the month, and there are a lot of other options that could bring greater returns.

    By Kim,

    • 0 comments
    • 418 views
  • Jade Lizard Options

    The jade lizard is one of those bullish spreads with limited maximum profit, and no risk on the upside. It is a combination of a short put with a short call spread . The credit this creates is higher than the span of the spread. To set this up, two actions are required:

    By Michael C. Thomsett,

    • 0 comments
    • 709 views
  • Are Your Emotions Trying To Tell You Something?

    As a trader, you may find yourself frequently trying to ignore or rationalize emotions.  You may have even created your own “solutions” to manage them. You exit early to lock up profit and avoid a potential blow-up if the trade turns against you.

    By Jared Tendler,

    • 0 comments
    • 444 views
  • Stock Trading Basics: 5 Rules for Successful Stock Trading

    You might be a stock trader, or just interested in learning more about how to trade and make the most out of your stock investment. Regardless, successful stock trading is not that easy. You must first have the financial capital to start and a very great endurance for risks.

    By Kim,

    • 2 comments
    • 623 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