Options Forum: Know Your Strategy

Costs vs. Rewards

Another factor to consider when choosing positions is the return based on the capital or margin requirement needed to establish the position. This provides a truer reflection of an strategy's potential return on investment.

When buying options, the ROI formula is fairly straightforward: The capital requirement is equal to the purchase price of the option. But ROI gets slightly more complicated when you're selling options.

The margin requirement for selling an uncovered or "naked" call is the greater of:

1. 20% of the stock price plus the call premium, less the amount that the call is out of the money, or
2. 10% of the stock price plus the call premium.

In the XYZ example above, the margin requirement equation is (0.20 x $47.50 + 1.50) - 2.50 = $8.50, or $850 per call sold. (The latter formula results in a requirement of just $800, which is the lesser of the two and therefore not applicable.)

Use the margin requirement as the basis for calculating the return on investment for the position. In XYZ's case, assuming the call expired worthless, the ROI would be 17.6%, which is derived from dividing the profit by the initial margin requirement ($150/$850). Remember that this was achieved in just a seven-week period, and there is no reason to annualize the return. Still, even without annualizing the return, this formula illustrates the leverage of options and the power of time decay.

Achieving a similar return by buying the underlying shares would have required both $2,375 of initial capital (100 shares at $47.50 with a 50% margin requirement) and XYZ to climb by $4.00, or 8.6%, to $51 per share.

Parallel Positions

These calculations become more important when comparing two parallel positions, or strategies that have basically the same risk/reward profile. For example, a covered call or buy-write has essentially the same risk/reward in dollar terms as shorting its related put. But a look at the initial margin requirement for a covered call shows that these mirror or replacement positions can have very different returns on investment.

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