How to calculate ROI on credit spreads

D

Derrenoption

Hello,

There seems to be an important thing I don't really understand when it comes to
ROI for a credit spread.

I have seen the below calculation example from a reliable source which leaves me
with this question I have. So the credit spread has a max profit of $40, Max Loss $162
and have a chance of winning of 70%

POM/% of winning: 70%
Max Profit: $40
Max Loss: $162
Days to expiration: 57

Now, this formula is used which I can read and I do understand the caculation "as it is written" below:

$40 Profit / $162 Margin = 24.5% ROI
24.5% ROI X 70% = 17.15% / 57 = 0.30% ROC

So the calculation tells that if we multiply 24.5% x 70% we get the actual ROI which is 17.15% as it is 70% chance of winning and divide that on 57 days to get how much this position earn per day which gives 0.30%.
This is what I don't understand. How can it be like that?

Question 1:
Is it true that 17.15% is what this position earn on average over say 10,100 or say 1000 trades?

Question 2:
This is the initial problem I stumble upon. 70% chance of winning means that we win 7 trades and loose 3 trades. If we for the example assume that we make Max win and Max loss.
Shouldn't the calculation be like this where we actually loose -$200 in the long run(10,100,1000 trades etc)?

Total Profit: 40$ + 40$ + 40$ + 40$ + 40$ + 40$ + 40$ = $280
Total Loss: $160 + $160 + $160 = $480
SUM: $280 - $480 = -$200
 
Last edited:
Honestly, you are thinking about it too much. ROI doesn't mean much unless you are looking at the total amount of capital needed to commit to the strategy. In actual trading you don't know what your % win will be going forward, you don't know the distribution of trades. Viewing it as "return on margin" when no trader could reasonably run the strategy on just margin is a gimmick. I say, stop worrying about it and just try to create a few ideas with an edge, commit some capital, and see how you do.
 
>> In actual trading you don't know what your % win will be going forward

This I know. The question is purely mathematical. If I cant understand that, I can't understand the rest.
My question is just if we assume that we will have 10 trades that will follow the formula. Then in my view we will have a loss in the end.

This is our numbers for the trade. Now we ASSUME we have 10 trades that meets exactly this for the sake of the example:

POM/% of winning: 70%
Max Profit: $40
Max Loss: $162

So our ROI is:
$40 Profit / $162 Margin = 24.5% ROI

Now I stumble on this. We have 70% chance of winning. So we will win 7 trades and loose 3 trades. I wonder if that is the case?

If that is the case, isn't this what is going to happen practically, that we after the 10 trades has a -$200 loss?

Total Profit: 40$ + 40$ + 40$ + 40$ + 40$ + 40$ + 40$ = $280
Total Loss: $160 + $160 + $160 = $480
SUM: $280 - $480 = -$200
 
I still struggle with the ROI. I can't find anywhere on the internet where they explain what can be a good entry condition when considiring the risk/reward ratio for a sell PUT credit spread.

I know implied volatility is good if it is high but I wonder for the win/loss ratio. In below example we have a ROI of 12.4% and a probability out of the money: 80%.
That doesn't look good when calculation on it: If we win 8 times and loose 2 times assuming max win and max loss. That will give: -39,4 dollar

I will be really happy if anyone can explain this and how to think and look for. How does a typical entry looks like when it looks good etc. I would need some example. The calculation below really bugs me as it shows negative as I have described:

Sell PUT at strike 5.5: 0.11
Buy PUT at strike 5.0: 0.055

CREDIT: 11 - 5.5 = 5.5
Max Loss: 50 - 5.5 = 44.5
ROI = 5.5 / 44.5 = 12.4%
Probability OTM = 80%

We win 8 times and loose 2 times:
Wins: 8 * 6.2 = 49.6 dollar
Loss: 2 * 44.5 = 89 dollar

TOTAL gives minus: 49.6 - 89 = -39.4 dollar
 
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