Is Your Options Position Getting Enough Credit?
Is Your Options Position Getting Enough Credit?
- Selling options automatically offers limited profitability, so it’s important to accurately assess the credit you collect at trade entry.
- To measure the “bang for your buck” on a short premium trade, look at its buying power efficiency.
- To see how your credit translates directly into return potential, look at the return efficiency of the trade.
Selling options is different from buying options. With a long option position, the potential rewards are effectively unlimited, but with a short option position, the most you can make is usually the credit you collect. Therefore, it’s important to interpret credits you might collect at trade entry correctly, so that the risk-return profile you’re establishing with that position is in line with your objectives. To do this, there are two different ways to analyze your credit collected on a short premium position: buying power efficiency and return efficiency.
Premiums and buying power efficiency
One of the simplest ways to check whether the credit you collect gives you enough of a “bang for your buck” on a short premium position is to check your buying power efficiency. By taking the credit collected and comparing it to the overall buying power required to hold the position, you’re able to see just how many dollars of potential profit (the credit) are coming in relative to the dollars required to hold the position (the buying power). Generally speaking, you should shoot for a buying power efficiency of at least 10%, but many times with higher priced stocks or stocks with a greater implied volatility, your buying power efficiency can easily get close to or exceed even 20%.
Premiums and return efficiency
Another way to interpret your credit collected on entry is by thinking in terms of the return efficiency of the trade. Given our preference for entering positions around the 45 days-to-expiration (DTE) marker, it’s easy to see that there are approximately 8-45 DTE time intervals available to you throughout the year. Therefore, if you were to collect a credit that was equal to 1% of the underlying stock price, then that would amount to the potential for an 8% return from that premium across the year.
Now to be clear, this assumes every trade works perfectly, you carry them all to expiration and they all expire fully out-of-the-money. This is not a realistic outcome, especially given that we often manage our winning trades early, before expiration, in an effort to more efficiently allocate the capital in our portfolios. Therefore, it might make more sense to strive to collect 1.5%, 2% or even more of the underlying stock price. Regardless of the specific percentage target you choose, viewing the credit collected in terms of return efficiency can give you a unique way to analyze your potential trades.
Jim Schultz,Ph.D., a derivatives trader, fitness expert, owner of livefcubed.com and the daily host of From Theory to Practice on the tasty live network, was named North American Natural Bodybuilding Federation’s 2017 Novice Bodybuilding Champion. @jschultzf3
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.