Calculating ROI on Your Option Trades

09/11/2013 7:00 am EST

Focus: OPTIONS

Even though at first glance, figuring out profit on your option positions appear to be easy, there are complications, note Seth Freudberg and Michael Schwartz of SMB Capital.

One of the questions often asked about investing in options is "How much can I earn"? Questions like this show how easy it is to fool someone if they really don't understand how to measure trade results from one trade to the next. To put it bluntly most options trading books don't tell the whole story.

One marketing approach actually used for selling option trading education goes something like this: "How would you like to make 100%, 200%, or even 300% on one option trade and only risk as little as $100"? Wow, doesn't that sound like a great opportunity? But is it really?

When you understand how options work, you can see that the problem with a statement like this is that they are mixing two different types of data! They are using return percentage for gains and dollars for risk. If the statement was entirely in percentages, it would say you can make, 100%, 200%, or even 300% while risking as little as 100% of your capital. Sounds a little different when you know you are risking 100% of your money on that trade!

One would think that options trading returns are easy to calculate, but there are some complexities. About one year ago there was an article written in a trading periodical about an options trader. To determine the average return of this trader, the writer of the article took each monthly result and averaged 12 months to come up with the average return for this trader.

The problem is each month's return was based on the risk that was present in each particular month's trade. Why is this a problem? To explain this, we need to know the right way to calculate returns. There are only two approaches: 1) Return on total portfolio balance or 2) Return on allocated capital.

Return on total portfolio balance is as straightforward as it gets. If you have a $100k portfolio and you put on a single trade in that account and make $1,500 you made $1,500/$100,000 = 1.5%. But suppose you only had at risk in that particular trade $3,000, wouldn't your return be 50%? The answer is not that easy.

The missing link is that a lot of option trades will require an adjustment, or series of adjustments during the life of the trade. Adjustments normally require additional risk capital. Professional option traders know this and thus allocate (set aside) trading capital in case it is needed for adjustments. So while you made $1,500 on $3,000 of risk, you might have allocated $15k for that entire trade because history tells you that you may, in certain months, need that much capital to properly adjust the trade.

If that was the cash put aside for the trade, your real return was $1,500/$15,000, or 10%. That's a little less than 50% last time I checked! So in the iron condor example above, the problem the author of the article made was ignoring allocated capital. In some of the positions, the trader in the article made multiple adjustments and increased trading size each time by 1.5 times his original position! That changes the return calculation drastically.

By Seth Freudberg and Michael Schwartz of SMB Capital

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