Options math 101 - Net returns from an unexercised put

[newwurldmn]

I use the underlying price to calculate risk/coverage/headroom/margin of safety.

Let me ask my question differently: I sell a put waaaay out of the money. Say 90 per cent away from current stock proce. I would like to be able to compare the return on equity allocated to this options to dividends paid by prefs and junior debt across the capital structure.

i would use the strike price as my denominator.

don’t use margin and worse, don’t use premium received/paid. Both are forms of extreme leverage and obfuscate real return to risk or capital.

for example, you sell an atm put. Is your return 20percent whereas if you owned stock your return would be a lot lower? Would you dare invest the same dollar value in the put as in the stock? Of course not. In the downside the risk And the pnl is essentially the same. Shouldn’t the return be the same as well then?

only worry about the margin to see how much rope you still have left. Ideally it should be a lot of rope.

 

[guru]

Very true. But I am trying to figure out how much of my equity is being locked away and not available to use for other trades. Everyone should be interested in that no?

It’s difficult because it changes daily, while it’s the risk that matters. The broker reserves the margin and if you have more equity in other stocks and cash then that’s the portion of your equity, otherwise you’re borrowing the reminder.

Personally, I’ve got used to not paying attention to it after I saw my margin swinging +/- $30K on some days, and not always in the way I’d expect. Though I mostly trade complex options when the market dropping may sometime decrease my equity and take more margin, while in other cases may increase the equity and improve my margin, while other times just change my margin. So managing this comes with experience more than theory, at least for me.
I’d recommend that you start trading options safely (which you already seem to plan to do) and later observe how it affects your equity and margin. Any other answers will be theoretical and you’ll still end up being surprised and adjusting your math after you take the trade.

 

[Poljot]

Your max risk on this trade is 141k.
Consider a spread to lower the risk and margin by adding one long put leg at a different strike.
See how that impacts your margin.

 

[xandman]

I use the underlying price to calculate risk/coverage/headroom/margin of safety.

Let me ask my question differently: I sell a put way out of the money. Say 90 per cent away from current stock price. I would like to be able to compare the return on equity allocated to this options to dividends paid by prefs and junior debt across the capital structure.

The return on equity you would be comparing across the capital structure is the ROE on an unlevered basis. This is supported by CAPM and Capital Budgeting models.

The ROE on your account equity is actually ROI. The premium you received is Cash Flow Return which still be adjusted by possible loss from exercise to get Net Return.

Either way, not very useful for a trader. You want to calculate values that will aggregate easily to get the total portfolio exposure across different products and assets. Underlying/Notional/ Unlevered basis will help you form an easy mental model of risk and return.

If you start doing volatility or curve trades, you will need a computer.

 

[tonyf]

The return on equity you would be comparing across the capital structure is the ROE on an unlevered basis. This is supported by CAPM and Capital Budgeting models.

The ROE on your account equity is actually ROI. The premium you received is Cash Flow Return which still be adjusted by possible loss from exercise to get Net Return.

Either way, not very useful for a trader. You want to calculate values that will aggregate easily to get the total portfolio exposure across different products and assets. Underlying/Notional/ Unlevered basis will help you form an easy mental model of risk and return.

If you start doing volatility or curve trades, you will need a computer.

I am not a trader in the sense that I have no interest in closing far OTM puts before they expiry. Your lingo is correct: nominator is cash flow and ROE is ROI.

Question is where to find the locked away (or assigned) equity for a given option trade in TWS.

Sorry everyone, I know that you all mean well with all the risk warnings (and I am paying attention) but I keep coming back to the same question: my equity allocation.

 

[tonyf]

I am not a trader in the sense that I have no interest in closing far OTM puts before they expiry. Your lingo is correct: nominator is cash flow and ROE is ROI.

Question is where to find the locked away (or assigned) equity for a given option trade in TWS.

Sorry everyone, I know that you all mean well with all the risk warnings (and I am paying attention) but I keep coming back to the same question: my equity allocation.

A different angle of asking exactly the same question: 2 out options for 2 stocks of about same market cap and different volatilities. Way out of the money, strike 50% away from current price. Premium is exactly the same. One requires twice more maintenance margin than the other. I have such examples in front of me....
If calculating ROE as Cash Flow / Maintenance Margin, one put is twice more profitable. I am trying to figure out the relationship between maintenance margin and equity to understand this further.

 

[xandman]

I am not a trader in the sense that I have no interest in closing far OTM puts before they expiry. Your lingo is correct: nominator is cash flow and ROE is ROI.

Question is where to find the locked away (or assigned) equity for a given option trade in TWS.

Sorry everyone, I know that you all mean well with all the risk warnings (and I am paying attention) but I keep coming back to the same question: my equity allocation.

Trader and investor lines get blurred when most are really just seeking a better risk return than passive investing. And, no single trade exists in a vaccuum. Say I have a $1.6 Mill. portfolio. That TSLA option controls $160,000. A 10% allocation on a stock that could loose 50% instantly on a major fraud investigation. A 5% hit on the portfolio with 1 holding. The smaller computations don't really matter as much as that one.

 

[tonyf]

Trader and investor lines get blurred when most are really just seeking a better risk return than passive investing. And, no single trade exists in a vaccuum. Say I have a $1.6 Mill. portfolio. That TSLA option controls $160,000. A 10% allocation on a stock that could loose 50% instantly on a major fraud investigation. A 5% hit on the portfolio with 1 holding. The smaller computations don't really matter as much as that one.

Again. Risk. Agreed.
Say no investigation, and puts expire worthless. What equity was allocated to that trade?

 

[xandman]

Again. Risk. Agreed.
Say no investigation, and puts expire worthless. What equity was allocated to that trade?

The equity allocated to the trade are the funds earmarked for margin that you could not use.
I suspect you were a professional accountant or a real estate investor due to your adherence to this equity concept. Great for reporting purposes, but it does not map well to key risk concepts. But I respect it and will try to express things in that vernacular if I can.

A different angle of asking exactly the same question: 2 out options for 2 stocks of about same market cap and different volatilities. Way out of the money, strike 50% away from current price. Premium is exactly the same. One requires twice more maintenance margin than the other. I have such examples in front of me....
If calculating ROE as Cash Flow / Maintenance Margin, one put is twice more profitable. I am trying to figure out the relationship between maintenance margin and equity to understand this further.

You will end up finding a correlation between high volatility and high ROE. So, this is a prime example why defining high ROE as a criteria for stock option selection is very dangerous. Volatility is the center of the universe for option trading ( and should be in everything else, imho).

 

[tonyf]

The equity allocated to the trade are the funds earmarked for margin that you could not use.
I suspect you were a professional accountant or a real estate investor due to your adherence to this equity concept. Great for reporting purposes, but it does not map well to key risk concepts. But I respect it and will try to express things in that vernacular if I can.



You will find a correlation between high volatility and high ROE. So, this is a prime example why defining high ROE as a criteria for investment selection is very dangerous. Volatility is the center of the universe for option trading.

Thank you!

So 1) Maintenance Margin in my first question = Equity.
2) Maintenance Margin is not fixed and varies intra-day
3) Nominator (Cash flow) is set on trade date (day I sell a put). ROE/ROI changes daily as Margin changes daily.
4) IB does black magic (nothing on their website or help files) to calculate Maintenance Margin as a function of change in Vol and likelihood of exercise.
5) There is no possibility of pulling maintenance margin in Excel with DDE API (to be confirmed, but that's my understanding thus far).

Risks on the side, is my understanding correct?