By: Steve Smith
My articles this week on calculating a Twilio (TWLO) profit and Capital One Financial (COF) loss continue generating questions on how profit and loss calculations are applied to overall returns? So, I’ll dive a bit deeper into the topic.
It’s a well-known investment maxim that risk is correlated to reward. But, when it comes to options trading, it seems people are often making claims to consistently hitting singles while simultaneously being home run kings.
I’d like to take this opportunity to explore how returns should be calculated, whether it’s possible to achieve a high percentage win rate along with high percentage returns. And finally, which options trading strategies offer the best probability of consistent profitability.
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. For example, if a call option they own increases in value from 50 cents to a dollar, they’ll tout a 100% return. But, if it expires worthless, they’ll highlight that the loss was limited to just 50 cents or $50 per contract, not that it was a 100% loss.
Both of these are true, 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 the straight purchase of a single strike, or for 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 20 cents to 50 cents, that is a 150% gain. But, if one only owns two contracts within a $10,000 portfolio, that $60 gain translates into less than ½ 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 50 cents, credit was forced to cover and bought back for a dollar, it was “only” a 50c loss. But, even this doesn’t accurately reflect the margin or capital required to establish that the short position could’ve been over 50 cents, and therefore the loss was even greater than 100%.
Here’s a basic example in the SPDR S&P 500 (SPY). With the SPY trading around $435, you can sell the 440 call and buy the $443 call for $1.20 net credit for the spread, which expires on March 18. If SPY shares are below $440, then the position expires worthless on March 18, 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 $273 on the expiration date.
Therefore, the maximum profit of $1.20 represents a 66% return. Not too shabby for a 30-day period, but not the 100% claimed. However, that also means the potential loss of $1.80 translates into a 150% or 1.5X the profit potential. It’s always important to keep in mind both the percentage and dollars at risk. This needs to be in the context of 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 options trading strategies. In the next segment, I’ll look at how winning big can outweigh winning often but can bring its own pitfalls.