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Here is a snapshot of the discussion: 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: 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. Related articles: Selling Strangles Prior To Earnings Selling Naked Put Option Karen Supertrader: Too Good To Be True? How To Blow Up Your Account
AGGREGATE vs. ROI When you start looking at the different ways in which trading results are analysed, you’ll notice that they fall into two broad categories, Aggregate Analysis and Return on Investment analysis. Most investment services use versions of Aggregate Analysis which is a slippery slope into results that are at best misleading, at worst, deceptive. Let’s say, for example, that a service did one trade in the month. They make 10% on that trade. According to Aggregate Analysis, they would then claim that they had made 10% for the month. But did they? In another instance a service does 4 trades for the month, averaging 10%. They claim, according to Aggregate Analysis, that they made 10% for the month. Really? And probably the most common example is when they’re calculating yearly returns. Say they did 20 trades for the year and the sum of all those trades (that is, the return for each trade added together) was 100%. Their claim, according to Aggregate Analysis, was that they made 100% return for the year. How most services report returns So all Aggregate Analysis does (and this is where its name comes from) is add the results of the individual trades together. And you can understand why a service would do that – it’s not only simple but, most importantly, it shows off their performance in the best possible light. Hey, if you could do one trade and make 10% a month, why wouldn't you subscribe? Because you haven’t actually made 10%, that’s why. Not in the way that most people would think about trading or investment returns. 10% return assumes that you allocated your whole account to that single trade - which of course is insane. Let’s assume you have a bank of $10,000 and you’re risking 5% per trade because you’re trading options and options are risky. So that’s $500 maximum per trade. The trade makes 10% which is $50, so you’re out for $550. What return did you make for the month? $50 / $10,000 = 0.5% No, you did not make $1,000, as the 10% return suggested you would. You only made 0.5% because, normally, returns are calculated based on the total investment. And your total investment wasn't just the $500 you put at stake for that particular trade, it was the entire $10,000 you have in your trading account, because while it’s sitting there in your trading account it isn't doing anything else. You can’t have it invested elsewhere earning money for you – it has to be in your trading account so you can practice proper money management and risk allocation. How SteadyOptions reports returns? We will always report our returns based on the whole account. The performance of the model portfolio reflects the growth of the entire account including the cash balance. Some services consider a $500 gain on a $1,000 investment to be a 50% return when the whole account is worth $10,000. We consider this to be a 5% return — and that is the honest way of doing the calculations. We also always report performance based on the same allocation. Imagine a service making 3 trades per month and making 10% per trade. They would report 10% return. That means allocating 33% per trade. But wait - what if you need to adjust the trade? You absolutely need to keep at least 20% in cash for adjustments, so your real return is 8.0%. To add insult to injury, if they make only 2 trades in a certain month, they would still report 10% return. That means allocating 50% per trade. But how could you do that if you usually make 3 trades? Our Model portfolio is based on starting value of $10,000, compounded monthly and reset every year. We start with $10,000 each year and compound as the year progresses. Initial full position is $1,000 (10% of the portfolio) and half position is $500 (5% of the portfolio). For example: FB trade on 12/28/17 (last trade of 2017) produced 40% gain. If we make 40% on $500 it is $200. But we base the positions on the new portfolio value at the end of each month (23,551 at the end of November 2017) so full position is $2,355 and half position is $1,177. 40% of $1,177=$471, so the portfolio increased from 26,014 to 26,485. This is what compounding means. Our Steady Condors service has 2 trades each month and allocates 40% per trade, keeping 20% in cash. If each trade makes 10%, other services would report 10% monthly return. We would report 8% return because we kept 20% in cash. This is what we mean when we say "All Returns are on the whole account". Over time, the difference is HUGE. Our returns are extremely underestimated compared to most other services. There are a lot of other dirty tricks that some services use to push up their numbers. It might include reporting based on "maximum profit potential", calculating gains based on cash and not on margin etc. You can read my article Performance Reporting - The Myths And The Reality for full details. Still skeptical? Why not to take the SteadyOptions free trial and see by yourself how we are different from other services. Please refer to Frequently Asked Questions for more details about us. If you liked this article, visit our Options Trading Blog for more educational articles about options trading. Related Articles: Why Retail Investors Lose Money In The Stock Market Are You Ready For The Learning Curve? Can you double your account every six months? Performance Reporting: The Myths and The Reality Are You EMOTIONALLY Ready To Lose? Start Your Free Trial
Our readers and members know that our returns are verified by Pro-Trading-Profits, an independent third party website that tracks performance of hundreds investment newsletters. They have an excellent explanation how to analyze and compare performance of different trading systems. Here are some highlights of their article. Click here to view the article