Lesson Objective: Learning how to calculate your return and performance in option trading.
We hold three key tenets when calculating returns in option trading:
- Returns should be determined not only with respect to the investment (amount at risk) but also to the overall size of your portfolio. As such, there are two types of returns for each trade: the return on the amount invested, and the return on the overall value of the portfolio.
- Returns should be annualized.
- Returns should be compared to a benchmark, rather than considered in isolation.
Let’s go through each principle.
(1) a) Determining the Return on a Specific Trade
Calculating the return of a trade – and then on your overall portfolio – cannot be overstated as you should not trade options without reflecting on your performance and being able to analyze the aspects of the trades that went well and not so well. However, options can be tricky instruments and the concept of return depends on different factors, most importantly on how you define your initial investment.
In its simplest form, the return for a given trade is the realized gain or loss divided by the “amount invested” (or ‘at risk’). For instance, if you made $1,000 while you were investing/risking $5,000, that would be a 20% return (not annualized).
In the case of risk-defined strategies, the (non-annualized) return is easily calculated since you know both the numerator and the denominator. Let’s take a few examples:
- You buy a put for $4/share (denominator = amount invested = maximum risk = $400). The put is OTM at expiration, so you lost all your investment (numerator = $0) and your return is 0%.
- You buy a call for $4/share. (denominator = amount invested = maximum risk = $400). The call gives you the right to purchase stock XYZ for $100. At expiration, XYZ is at $110 so the option is ITM and exercised. Your realized gain (numerator) is $600 [($110 – $100) x 100 shares – $400 cost]. So, the return of the trade (return on investment) is $600/$400 = 150%.
- You enter into a bull put spread whereby you sell a put with a $250 strike and buy a put with a $230 strike (same expiration). Your maximum risk (investment) would be defined as $2,000 [($250- $230) x 100 shares] because even if the stock gapped down and you got assigned, you could immediately exercise your long put for $230 per share (or your brokerage firm would automatically do it for you, in particular if you are short of cash). This amount would also be the margin requirement per your broker. Let’s say that you received a net credit of $4 per share for selling the spread and both options expire worthless. Your return would be $400/$2,000 or 20%.
- You enter into a covered call by buying 100 shares of XYZ at $100 and selling an OTM option with a $102 strike for $4/share, so a net cost per share of $96. Net total debit of $9,600 [($100 – $4) x 100 shares], which is the amount invested and your maximum risk. If XYZ remains below $102 at expiration (option is OTM), then the return is $400/$9,600 or 4.2%. If XYZ is above $102 at expiration (option is assigned), then the return is $600 ($102 – $96) / $9,600 or 6.25%.
In the case of undefined-risk strategies such as selling naked puts, the amount at risk would typically be the margin requirement as determined by your brokerage firm. This is generally fine if your approach to the strategy is that of a trader (i.e., your intent is to close your position before any significant risk of assignment). However, if your intent is to take assignment if the trade goes against you (i.e., you would not mind becoming an investor in the underlying), then we believe that you should use the maximum capital at risk i.e., the strike price multiplied by 100 (number of shares) and by the number of contracts as the invested amount.
For instance, you sell one put on stock XYZ with a $100 strike for $2/share ($200 total premium received), and the margin requirement (i.e., initial amount at risk according to your broker – see lesson on Margin Requirements) is $2,000. Assume that the option is OTM at expiration.
If you entered the strategy with a trader mindset, then your return would be 10% ($200/$2,000). If instead, you entered the strategy as a potential investor, you would have set aside $10,000 in cash ($100 x 100 shares) between the date of entry and the expiration of the option to stand ready in case of assignment. Consequently, your return would be $200/$10,000 or 2% over that period of time.
(2) b) Determining the Return on The Portfolio
We believe that when determining the return of your portfolio you should neither aggregate nor average the returns of the individual trades without taking into account all the components of your portfolio, including cash if applicable. You can look at the return of the portfolio at different points in time but we typically use the initial market value of the portfolio for the period. Such period could be regularly reset, like every week, month, quarter, or year, depending on your time horizon for determining performance.
For instance, if your portfolio had three trades with respective returns of 10%, 15%, and 20% and a significant cash portion that represented 50% of the portfolio, one should not argue that the (average) return of the portfolio was 15% because this would overlook the cash position. Instead, the return would be closer to 7.5% (15% x 50%).
In fact, we would favor calculating returns weighted by the maximum potential risk as calculated in section (1) a) above.
Let’s go back to the four examples above. Assume that you have $20,000 in cash (initial market value), then you immediately:
- Buy a put for $4/share. Cash left = $19,600. Maximum risk of $400.
- Buy a call for $4/share. Cash left = $19,200. Maximum risk of $400.
- Sell the $250/$230 bull put spread for $4/share. Cash left = $19,600. Maximum risk of $2,000.
- Sell a covered call by buying 100 shares of XYZ at $100/share and selling the $102 strike call for $4/share. Cash left at inception = $10,000. Maximum risk of $9,600.
Now, let’s assume that all the options have the same expiration and the options in 1), 3) and 4) expire worthless while the call in 2) is assigned (strike of $100 so, cash outlay at expiration is $10,000). Here are the returns and maximum risks for each strategy:
- Buy a put for $4/share. Return 0%. Maximum risk of $400.
- Buy a call for $4/share. Return 150%. Maximum risk of $400.
- Sell the $250/$230 bull put spread for $4/share. Return 20%. Maximum risk of $2,000.
- Sell a covered call by buying 100 shares of XYZ at $100/share and selling the $102 strike call for $4/share. Return 4.2%. Maximum risk of $9,600.
Your average return weighted by maximum risk but disregarding cash would be based on these four options only with a total maximum risk of $12,400 ($400+$400+$2,000+$9,600):
(0% x $400/$12,400) + (150% x $400/$12,400) + (20% x $2,000/$12,400) + (4.2% x $9,600/$12,400) = 11.32%
However, we think that purporting a 11.32% return would be an exaggeration because this would simply ignore the significant cash position in your portfolio. Holding cash is usually a deliberate choice that gives you the option to take advantage of future potential opportunities instead of being invested right now. Such choice could prove timely or untimely. There is a myriad of other options such as being invested in a market-wide ETF or index like the SPY or SPX. Should the SPY/SPX be your benchmark and increase during that time by x%, your cash position would have a x% opportunity cost. Such opportunity cost should be part of your overall performance. Let’s see how this would affect the overall portfolio return:
5. Cash position = $10,000 between Day 1 and expiration so almost 100% of the time. Return: (close to) 0% (we assume that interest rates are negligible over the time period). The cash position represents 50% of the market value of the portfolio at inception ($20,000).
So, the actual return of your portfolio for the period is: 50% x 11.32% + 50% x 0% = 5.66%.
(2) Annualizing Returns
Returns can be misleading if they are not calibrated to a time yardstick. Having a 5% return over 1 year has nothing to do with a 5% return over one month, e.g., the difference is huge. For that reason, returns are usually converted to a time reference. The typical convention is to use one year.
An approximate way to convert from a Return (“R”) over “d” days to a yearly return “A” is:
Annual Return A in % = [(X+1)(365/d) – 1] x 100
For instance, if the 5.66% return above is for 60 (calendar) days, the annualized return would be [(5.66%+1)(365/60) – 1] x 100 i.e., about 40% per annum.
(3) Benchmarking Returns
Annualized returns taken on a standalone basis are lacking context if they are not compared to some benchmark. The rationale being that – in a world of choices – you always have some opportunity cost as soon as you make an investment decision since your capital is not ubiquitous and can only be allocated to a specific strategy/underlying. Therefore, you should have a clear idea of how your performance compares to other choices, in particular to the benchmark you deem most relevant.
It’s up to you to decide what benchmark is relevant in the context of your portfolio. If for instance, you mainly trade options on technology stocks, then QQQ or NDX could serve as your benchmark. If instead you trade options on large cap underlyings, SPY or SPX may serve you better. There is not a one-fit-all benchmark, it all depends on the specific components of your portfolio.
Please refer to Lesson 17 on Portfolio Balance for a detailed discussion on the importance of benchmarking.