Every trader, and especially those with smaller accounts, must be cognizant of their margin costs. Smaller accounts have tighter capital constraints and thus maximizing the potential return on capital (ROC) is usually a prime consideration. What are the ways they can do this?
There are two main ways to adjust the ROC in a smaller account. One way to do this is to change the strikes on defined risk spreads. The other way is by choosing higher implied volatility (IV) trades. When using the first way, changing the strikes on defined risk trades, there are two ways to do that. The first is to move the strikes closer to at-the-money (ATM). An example was shown using a vertical put spread in the SPY. The example included the credit received, max profit, max loss and buying power required, probability of profit (POP) and max return on capital for $2 wide put spreads at three different levels. Moving short spreads closer to the underlying price allows you to increase potential ROC but lowers your POP. Narrowing the width of the spreads is the other way to increase ROC. Another table showed examples of an Iron Condor with varying widths. Tightening the spreads increases potential ROC but lowers the credit received and impacts the breakeven prices also slightly lowering the POP.
Choosing higher IV trades is the other method for adjusting ROC. Just like changing the strikes on defined risk trades, choosing to make trades in higher IV situations comes with its own trade-offs. This is especially true for naked short positions in cheaper underlyings. Two tables were used to compare GDXJ (Gold Miners ETF) and YHOO. Although their prices were similar their IV and IVR were very different. The POP was similar on both but the high IV increased the max ROC by a large amount in GDXJ. The trade-off is a higher theoretical risk.
For more on Return On Capital (ROC) see:
Market Measures from September 16th, 2014:"ROC: Strangle Replacement"
Best Practices from February 2nd, 2015: “Key Metrics | POP & ROC”
Strategies For Your IRA from January 27th, 2016: "Maximizing Return On Capital"
Watch this segment of “tasty BITES” with Tom Sosnoff and Tony Battista for the important takeaways and the two ways smaller sized accounts can adjust ROC and the trade-offs involved.
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