We had a few questions about calculating the return and the risk/reward on spreads. (June 24, 2000)
Basically, we calculate the return by taking the money we take in (the net credit after selling the higher strike put and buying the lower strike put) and divide that by the margin requirement. If the spread is $5, the margin requirement is $5 per spread written. Thus, if the net credit is $1.62 and the spread is $5, we calculate the return as 1.62 divided by 5, or 32.4%.
Some who write about stocks would calculate the return as 1.62 divided by 5 (the spread) minus 1.62, taking out the net credit from the margin requirement. In this case, that would yield a 47.9% return-that is just playing with numbers, however. The fact is you need $5000 collateral for the trade, and that is how to calculate the return. Indeed, some out there would try to annualize that return and come up with some astronomical percentage return. If you do it every four weeks, okay. But don't take one trade and try to tell us you made 3000% annualized.
As for the risk/reward questions, we like spreads over many types of plays. Spreads can make you money even if the stock goes nowhere. If you buy a call or the stock, you need it to move up. With a spread, you have time working for you. As time ticks by, the options begin to lose value, all things being equal. If you wrote an out of the money spread (the stock was above the strike prices of the puts you sold and bought), the stock can do nothing and you still win. If it goes up you win. We like that a bit more.
With time working for you, not against, you, we like spreads. A 30% return in four weeks is a great return. You won't double your money in a week, but there are some huge advantages. First, you don't come out of pocket with cash to do the trade. You use someone else's money to get the credit. That is very nice. Second, you can put to use other assets you have that you would otherwise just be holding. What we mentioned last time was that you had to have $5000 collateral to write a $5 spread 10 times (i.e., 10 contracts bought and 10 contracts sold). Instead of cash, you could use stock you already own and plan on keeping. That way you can put stock you own longer term to work by using it as collateral for spreads. Indeed, you can even write covered calls on stock you own AND write spreads on it. Even if you get called out, and we don't write calls on our long term holdings to get called out, it does not matter, because you will have the $5000 cash from the stock sale to cover any possible loss. That gets pretty exciting to us.
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