By: Steve Smith
While everyone tries to figure out the election odds and what a Clinton or Trump win might mean, this might be a good time to revisit how to calculate the risk, reward and rates of return on option positions.
It’s a well-known investment maxim that risk is correlated to reward. But when it comes to options it seems people are often making claims to both consistently hitting singles while simultaneously being home run kings.
In these next three articles I want to explore how returns should be calculated, whether it is possible to achieve both a high percentage win rate along with high percentage returns and finally which option strategies offer the best probability of consistent profitability.
Dollars to Donuts
First we need to be clear on our terms. Returns must be based on dollars at risk. Too often people mix and match these terms to put their results in the best light. Meaning if a call option they own increases in value from 50c to $1 they will tout the 100% return. But if it expires worthless they will highlight the loss was limited to just 50c or $50 per contract, not that it was 100% loss. Both of these are true of course, but the varied emphasis can be misleading. But at least when purchasing options the accounting is fairly straightforward. The capital required and the risk are limited to the cost or premium paid for the position. This is true for straight purchase of single strike or spread done for a debit.
Because of the leverage of options many long premium positions can deliver returns in excess of 100%. Indeed, if an option goes from 20c to 50c, that is 150% gain. But if one only owns two contracts within a $10,000 portfolio, that $60 gain translates into less the one half of 1% return on equity.
When it comes to selling options or positions done for a credit the accounting can become a bit more creative. If it expires worthless a claim of a 100% return is often made. If the option position sold for a 50c credit is forced to cover and bought back for a $1, it was “only” a 50c loss. But even this does not accurately reflect the margin or capital required to establish the short position, which could have been greater than 50c and therefore the loss was even greater than 100%.
Let’s look at a basic example in the Spyder 500 Trust (SPY). With the SPY trading at $205.50, you can sell the $206 and buy the $209 call for $1.20 net credit for the spread with a February 20th expiration date.
If shares of SPY are below $206 on February 20th the position expires worthless and you keep the $1.20 premium as a profit. But this is NOT a 100% return. That’s because the margin or capital required to establish the position is $1.80. That is calculated by the width between the strikes, which is $3, minus the premium collected, $1.20. That $1.80 represents your maximum risk or loss that would be incurred if SPY is above $209 on the expiration date.
Therefore, the maximum profit of $1.20 represents a 66% return. Not too shabby for a 10 day period, but not the 100% claimed.
But that also means the potential loss of $1.80 translates into a 150% or 1.5X the profit potential. It is important to always keep in mind both the percentage and dollars at risk. This need to be in the context of both each individual position and the overall portfolio.
This concept of risk adjusted returns is crucial when we begin to look at the risk/reward ratios of various option strategies. In the next segment I’ll look at how winning big can outweigh winning often but can bring its own pitfalls.