Steven Smith

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Options Forum: Costs and Returns

Steven Smith

Steve,

What do you think the margin requirement would be on the butterfly trade you mentioned?

-- Gus

On a long butterfly such as the one described in last week's column, where one is shorting the middle strike, the margin requirement should be equal to the net debit of the position, because the maximum loss of such a position is limited to its cost. In the example provided, that would be $14 for each 1x2x1 spread.

Margin requirements on long option or net debit positions are easy to calculate, but short option, net credit or multileg positions are more complicated and must be taken into consideration before entering a position. Some of the basic rules regarding option margin requirements were discussed in this previous article.

For those too busy to click and read through that past pile of words, the basic formula for calculating margin requirements on short options is as follows:

The margin requirement for selling an uncovered or "naked" option is the greater of 1.) 20% of the stock price plus the put premium less the amount that the put is out of the money; or 2.) 10% of the stock price plus the premium collected.

For out-of-the-money credit spreads, this basically translates into an initial requirement equal to the width, or price difference between the strikes. But as always, requirements can vary depending on brokers, your level of trading or account balance. As we'll see below, the condor position described in Wednesday's column should be considered two offsetting credit spreads with a risk limited to just one side, and therefore not subject to a double margin.

I have only traded the long side of options and for the most part was unprofitable. I was thinking of learning more, and your articles have provided a good starting point. My question is, what kind of rates of return would a nonprofessional expect to achieve using spreads like the condor and others you write about? Is there an average rate of return? What strategies do you favor and have the best returns?

Thanks,
Derek

As I wrote in a July 2004 column, rates of return, or return on investment (ROI), should be calculated on the basis of margin requirements. Before we even get to ROI, let's have complete understanding that even on limited-risk long option positions, the potential loss is 100%, or the total amount of the initial investment. Of course this is true, at usually a far greater dollar amount, with the purchase of any stock, too, so don't let anyone tell you how risky options are. Options are a tool, and like a hammer, it can be used to build or destroy. Or options can be something that just keep you busy, such as my Web site "One Good Whack to the Head," which is still under construction.

One trap, marketing ploy or general fallacy often encountered in the world of calculating options returns is that people often use calculations based on dividing the premium collected by the share price and then annualizing the return. This is often seen in net credit or positions that mostly benefit or profit from time decay, such as straddles, strangles, condors or even covered-call programs.

There are two problems with this method. First, it's not based on your true cost or capital requirements. Second, the annualized return is based on the assumption that this position is repeatable another 10 times over the next 52 weeks.

Summing up, here are some general rules of thumb for calculating how your option trades are performing:

• Look at each trade on the basis of its specific risk-reward as calculated on the margin requirement.
• Do not annualize the returns. While it might look nice to extrapolate the numbers, most option trades are not continuously repeatable events, or least they should not be expected to be so. If you can repeat profitable strategies throughout the course of the year, the numbers will bear themselves out. There's no need to get stuck reusing a particular play on the belief it must deliver similar results over time.
• Find the strategy that best fits your current market thesis. One that delivers a small profit is much better than sticking with a "favorite play" that makes no sense in the current environment or your current holdings. As options are time-sensitive, it will cost you money trying to ride out a square-peg strategy during a round-hole period. Find an alternative or take some time off.
• When in doubt about anything concerning your margin requirements or obligations, call your broker and get clarification as to its specific rules and procedures. In the long run, it will save you both money and aggravation.