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Calculating profits and establishing break-even points are an important part of managing your trades, and as such you need to be aware of the key concepts. As with money management, the different trading strategies have different calculations. You need to consider two steps: what is your break even point (so that you know where your profit starts to kick in); and what your profit will be as the trade progresses.
- Stock trading
At the simplest level, you simply calculate the amount of value by which the stock has grown, and record it as a percentage.
So, if you purchased 100 shares of a stock worth $25, your total trade is $2,500. If your stock climbs to $28, you have made $3 profit per share, which is 12% profit. Or, your total trade is worth $2,800, which is $300 profit, and is still 12%.
Your TRUE profit however, must include broker's fees and commissions. So, for a stock trade, you may pay $0.015 per share. The above trade would therefore work out as follows:
Buy 100 shares @$25 = $2,500 + $1.50 = $2,501.50
Sell 100 shares @$28 = $2,800 - $1.50 = $2,798.50
True profit = $2,798.50 - $2,501.50 = $297 = 11.88%
Your break even point is $2,501.50, and you are only into profit zone AFTER you have crossed that threshold.
So, what's the big deal? Your trade cost $3, or you dropped 0.12%. Small change!
Well, with options, it is a big deal, because options are expensive to trade in the first place, and as soon as you start working with combinations like spreads and butterflies and so, the commissions rack up pretty quickly. This is offset by the huge profit potential of options, but you still need to calculate it so that you know what your true profit is. So, onward....
- Buying Calls and Puts
At the simplest level, you buy one call option for a stock at a cost of $250. After a few days, your trade has gone well, and you the option is valued at $500, so you sell, thinking that you have made 100% profit. Well, no....
The broker's fee for this trade could be $12.95, or even $15 for some brokers (if you are an infrequent trader). So, let's look at it again:
Buy one Call @$2.50. Cost of trade = $250 + $12.95 = $262.95
This means that your option MUST go above $262.95 before you have made any profit. But then you have to sell the option again later, also at a $12.95 commission. So you true break-even point is as follows:
Buy one Call @$2.50. Cost of trade = $250 + 2x($12.95) = $275.90.
That is a whopping 10% increase in value that you must achieve before you even start to make profits! However, don't panic, because this kind of growth in value is extremely common in option trading. Most traders aim for at least 50% and usually 100% growth in their trade. If you find a site offering trades which 5% or 10% growth in their trades, check carefully to see whether they include broker's commissions!
How about the profit calculation? Here it is:
Cost of trade = $275.90
Sell @ $5.00. Profit = $500 - $275.90 = $224.10.
Profit from $250 = 89.6%
Profit from total investment ($275.90) = 81.2%
These are not bad percentages! Nobody will cry about getting an 81% profit in less than a week! However, don't think that you are getting 100% just because the value of your option has doubled. A true 100% profit would be when the option value reaches $5.52.
NOTE: this is the cost of trading ONE option. Usually brokers have a fixed fee per trade, or something similar, so the more options you buy in your trade, the lower the commission per option unit. So, as you capital grows and you can buy more options, your break even levels pull in substantially.
- Selling Options
To calculate your profit when selling an option (like a naked put), you are not actually investing money in the trade, so you cannot work out return on investment (ROI). However, you will need to put up margin to cover your trade, and so you work out your profit based on Return on Margin (ROM).
Therefore, if you sell a Put for $1.50, you are immediately credited with $150. If you need to put up $1,000 margin to cover this trade until expiry, your ROM is 15%. If you let the option expire, you only pay a broker's commission ONCE. So, in this case, your profit would be $150-12.95 = $137.05, which is 13.7%. If you buy back the option, and sell another, then you pay broker's fees for three trades! It can mount up!
What about break even?
If the strike price for the put is $25, and you sell a put for $1.50, you are credited with $150. If the stock sinks below the strike price and becomes an ITM option, you are not automatically in losing territory. Remember, you have been paid to sell the option. Therefore:
Break-even = $25 - $1.50 = $23.50.
In other words, as long as your stock doesn't drop below $23.50, you are still not making a loss. If you factor in broker's commissions, your break even is:
Break-even = $25 - $1.37 = $23.63
Again, this calculation is for ONE option. When your trade multiple options, your cost per option is much less, and so your break-even calculation changes each time.
- Selling Credit Spreads
Whenever you sell a credit spread, you are simultaneously buying one option and selling another. This means two option trades. If your broker charges per trade, then your profits and break evens are calculated exactly as if your were selling single options (look at ROM, not ROI). If you are charged per option unit, then you must double your cost of trade. For a butterfly or Iron Condor trade, you are trading four options at one time. Again depending on your broker, you are either paying less per option overall, or you end up paying four times the amount.
Break even for credit spreads is exactly the same. You can afford to let the trade move slightly inside the spread before you actually lose any money.
If you let the spread expire, then you only pay one fee. When you buy back the spread, and sell another, you pay fee for each transaction.
FINAL NOTE:
Options trading leads to substantial, exciting and spectacular profits. However, broker's fees are much higher than for stock trading, so be realistic about your profits. Also, there are myriads of newsletters out there giving great looking performance results. Make sure your read the small print, and make sure the brokers fees are factored in before choosing any particular provider.
When you sign up with a broker, make sure you know what their fees are running at. You sometimes have the opportunity to choose from several fee structures - make sure you choose the one that suits your trading level the best.
On my Review page, I will eventually have about 80 sites listed which provide option trading recommendations, many of which will offer autotrading services with ThinkorSwim and OptionsXpress. This will be great tool to help you choose such a service, should you require it.
Return from Profits & Break-even calculations to the Home Page
Move on to my review page for option trading newsletter providers
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