How do you calculate the rate of return (ROR) when buying and selling put options?
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4 Answers
RoR for options you bought is fairly easy:
(Current Value-Initial Cost)/Initial Cost gives you the actual return.
If you want the rate of return, you need to annualize that number: You divide the return you got above by the number of days the investment was in place, and then multiply that number by the number of days in a year. (365 if you're using calendar days, about 255 if you're using trading days.)
RoR for options you sold is much more complex:
The problem is that RoR is basically calculating the size of your return relative to the capital it tied up to earn it. That's simple when you bought something; the capital tied up is the money you put up. It's more complex on a position like a short option, where the specific transaction in question generates cash when it's put on.
The correct way to deal with this is to A) Bundle your strategy (options, stock and collateral) into one RoR where appropriate, and B) include any needed collateral to support the short option in the calculation.
So, if you sell a "cash-secured" put, where you have to post the money that you'd need to take delivery of the shares if they were put to you, the initial cost is the total amount you'd need to put the trade on: in this case, it's the cash amount, less the premium you collected for selling the put.
That's just one example. But the approach holds more broadly: if you're using covered calls, your original cost is the cost of the stock less the premium generated by the sale of the call.
What Jaydles said.
I think of each strategy in terms of Capital at Risk (CaR). It's a good thing to know when considering any position. And then conveniently, the return is always profit / CaR.
With covered calls it's pretty easy. Pay $1000 for stock, receive $80 in premium, net CaR is $920.
If you own the stock and write calls many times (that expire worthless, or you that you buy back), there are two measurements to consider. First, treat every covered call as a buy-write. Even if you already own the stock, disregard the real cost basis, and calculate from the moment you write the call, using the stock price at that time.
The second measure is more complicated, but involves using something like the XIRR function in a spreadsheet. This tracks the series as a whole, even accounting for times where there is no written call outstanding.
For the written put, even though your broker may only require 30% collateral in a margin account, mentally treat them as cash-secured. Strike less premium is your true CaR. If the stock goes to zero by expiration, that's what you're on the hook for. You could just compute based on the 30% collateral required, but in my view that confuses cash/collateral needs with true risk.
Note: a written put is exactly identical to a covered call at the same strike. If you tend to favor puts over CCs, ask yourself why. Just like a loaded gun, leverage isn't inherently bad, but you sure want to know when you're using it.
Rate of return is (Current value - initial value) divided by initial value.
Buy $10,000 worth of put options and sell them for $15,000, and your rate of return is 0.5, or 50%.
All good advice but you're calculating returns on risks that may never materialize. Like buying a house for $100,000. Collecting rent with a net profit of $10,000. We would naturally consider that 10% return on capital. However, you would never factor in unknowns or possible depreciation of home to $90,000. It would be impossible to predict and can only be calculated at time of transaction. In that case your return is ZERO! Same with selling a put option. If your broker deposits $100 in your account (for selling a put) and it expires worthless you just made 100% profit...really on money that you did not have? If you use the suggestions that $100 credit might cause you to spend $10,000 to buy the stock, then your return is -98.99%. But you're only losing the difference between what your strike price is and what you can now sell the stock for...say it's $9,900, add your premium and your loss is 0%. But that same stock (you now own) can explode to upside or crash to downside! How can you, account for that until it actually happens?
