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Sunday, May 6, 2012

Debit Spreads - ROI (Return on Investment Calculation)

One of the things you often read when studying Options is that an acceptable exit from the trade is to predetermine the percentage you would like to make on your investment. Otherwise referred to as R.O.I.



WHY DO I CARE?

When I first heard about R.O.I., I thought to myself: Hey, I'm a beginner. I'm not looking to find out high faluting information on my profits just now. I'd just like to learn how to trade! And so I didn't pay much attention until I noticed that OptionsAnimal included such calculations on ALL of their lessons where R.O.I.was the primary exit strategy on the trade. And it was included because it was important and an integral part of the trade.

One good reason for it is the discipline to keep your trading a business and not a gambling event. If you are willing to limit your profit to a percentage, and then close the trade at that limit, you will also control your greed. (Don't forget that Fear and Greed are the trader's biggest enemies, and the very things that will/can do you in if you don't plan in advance.>

Then I discovered that it's not ONLY an exit strategy that all spread traders need to know, but that it's a calculation done in advance of the trade TO DETERMINE WHETHER YOU SHOULD EVEN BE IN THE TRADE! In other words, if you like to make (for sake of discussion) 50% profits on your trades, can your underlying equity move enough to even get you to the desired return on your investment? You won't know unless you do the math. Most conservative traders shoot for 25% to 35%, by the way. Oink oink here! I, of course, thought of 50%. But it's your business, make it what you like. But do the math!



SO, WHAT ARE THE STEPS?

What Return Do You Want?

1. Decide what return% you would like on your investment. For the sake of a lesson, let's say 25% would be enough to keep you happy. (that's a lot more than the banks are paying, right?)

What Trade Do You Want?

2. So, you decide on a trade. Let's say we think that IBM is going to go up, and we would like to put on a Bull Call vertical debit trade. So after looking at the chart and the fundamentals, you are fairly certain this stock is going to go UP. So you pull up an option chain and look for the premium it will cost you to do a spread.



The stock is currently selling for $200 per share. So we plan to buy a LONG Call (Buy to Open) (our primary instrument) at the Strike Price of $205 for $4.05.

We plan to sell a SHORT Call (Sell to Open)(our secondary instrument that reduces our cost) at the Strike Price of $210 for $1.97.

So, our investment in this spread is $4.05 minus the credit we get from the sale of $1.97 which equals $2.08 Investment. That is how much I will pay for this spread. It is my total maximum loss amount as well. It represents the cost for one contract which means that $2.08 x 100 shares (per contract) that I will have $208. taken out of my fund when I pull the trigger on this trade.

How Much Does My Spread Have to Be Worth To Win?

3. If we want to make 25% on this trade, ($.25-a quarter-for every dollar we put into it,) then add 100% to 25% and you get $1.25 as your multiplier. Always just add 1 in front of your desired ROI.

We are planning on spending $2.08 on the spread, right? So multiply $2.08 times $1.25 and you get $2.60. So that is what our spread needs to be worth at the time we reverse the trade. It will be our Net Credit after Selling to Close the Long Call, and Buying to Close the Short Call. $2.60.

Check my Math: Investment: $2.08 x ROI desired 25% = $.52 profit. Add profit to cost basis (which you want back too!) $.52 plus $2.08 and you get $2.60. In other words 52 cents represents 25% of our investment. In this trade, we want to get back our $2.08 plus $.52; that figure to reach is $2.60.



If you look at the Option Chain at the time of the trade, you can see that this spread is already depreciated. We paid $2.08 but if we reversed the trade right this minute, we would only get $1.93. Sell to Close the Long Call for $3.95 less Buy to Close the Short Call for $2.02. The difference is $1.93.

So this tells us that we need our option spread to increase in value from $1.93 all the way to our ROI figure of $2.60. The option spread has to increase in value by $.67 cents.

Well, do we just sit here and wonder if it will, and how it will or do we figure out how this thing works?

HOW MUCH DOES THE STOCK HAVE TO MOVE FOR MY OPTION TO MAKE MY ROI? Isn't this the real question? How do we know if this stock will cause that option spread to reach our goals?

The answer is another calculation. (Nobody told you that option trading was easy, did they?)

You probably know that DELTA is what tells you how much the option moves versus every dollar the stock moves. And both your long and short calls have Delta. The Long Call delta is positive, and the Short Call delta is negative. So let's take a look at that.

NET POSITION DELTA

Trade Monster has neat option chains where you can configure the columns any way you want. So I'm using their chain to show the Delta on this trade. Remember that the SHORT is negative delta, so we will subtract it from the LONG to get our Net Position Delta:


So this shows us that our spread will move .18 cents for every dollar that the stock moves. In order for our spread to increase by .67 cents before expiration, we divide .67 by .18 = 3.72. Therefore, the stock has to go up $3.72 in order for us to reach our R.O.I.

Does this stock move that far? Does it move fast enough to make this much by expiration? Look at the Historical price quotes and your Chart to see just how fast it does move.

If the answer is Yes, then let's do it! Not really. I think IBM's going down. :-)

## Disclaimer: Everything in this blog related to options is for educational (hopefully) purposes only and is NOT any kind of trading advice or recommendations.

2 comments:

  1. An Aha moment for someone who thought he was more than a Newbie. The Option gods have humbled me once again. Thank you for this Blog.

    ReplyDelete