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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:

Lets examine two cases, using the same underlying (BABA).

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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