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Vertical Credit Spread and Iron Condor Spread profit/loss calculation is very simple but not widely understood. Let's start with some definitions:
Vertical Credit Spread: Buying and selling an equal number of options contracts on same underlying with same expiration, but different strikes. Cash is credited (collected) to enter trade.
Example: XYZ stock (XYZ) is at $19 is expected to stagnate or fall in price. Sell a $20 Call for $1.10 and buy a $21 Call for $0.90, both with 2 months until expiration. The result is a net credit of $0.20 ($1.10 - $0.90 = $0.20), or $20 per option contract .
When to employ: If a move sideways or lower is anticipated use Calls. If a lateral or rise is expected use Puts.
Iron Condor Spread: Buying and selling an equal number of options contracts using both Calls and Puts on same underlying with same expiration, but different strikes. Must have the same distance between the call strikes and put strikes. Cash is credited (collected) to enter trade. An Iron Condor is actually composed of 2 credit spreads, one Call Credit Spread and one Put Credit Spread.
Example: XYZ stock (XYZ) is at $19 is expected to go sideways. Sell a $21 Call for $0.80 and buy a $23 Call for $0.65. Also Sell a $16 Put for $1.00 and buy a $14 Put for $0.83. All with 2 months until expiration. The result is a net credit of $0.32 ($0.80 - $0.65 = $0.15) + ($1.00 - $0.83 = $0.17), or $32 per option contract.
When to employ: When the underlying is expected to be range bound.
What about Margin Requirements?
The amount of Margin required is defined as: "The value of the difference between the strike prices of the vertical spread". So, in the Vertical Credit Spread example above, the difference between the strikes prices of our options is $1.00. This means for each spread sold, $100 of Margin will be required. For 10 spread contracts, $1,000 of margin would be required.
Now that we have the basics down, let's walk through the performance calculation:
Performance Calculation:
Calculating performance for Vertical Credit Spreads, using the example spread portrayed above, would look like this:
Sell 1 Vertical Credit Spread for $0.20 credit.
Total Revenue = $20 ($0.20 x 100 share option contract = $20)
Margin Requirement = $100 (distance between strikes x 100 share option contract)
Commission= $10
Net Profit = $20 credit - $10 commission = $10 Profit after commission
Now here's where it gets interesting:
$20 credit was received with a $100 margin requirement. So, only $80 is truly at risk (we got paid $20 to risk $100).
Therefore, the true return for the trade (known as ROI) is: 12.5% (see the calculation steps below)
$100 margin - $20 credit received = $80 truly at risk
$20 credit received - $10 commission = $10 net credit after commission
$10 net credit after commission / $80 truly at risk = 12.5%
Net Profit Percentage / ROI = 12.5%
Calculate performance for Iron Condor Spreads, using the example spread portrayed above, would look like this:
Sell 2 Vertical Credit Spreads for $0.32 credit.
Total Revenue = $32 ($0.32 x 100 share option contract = $32)
Margin Requirement = $200 (distance between strikes x 100 share option contract)
Commission= $15
Net Profit = $32 credit - $15 commission = $17 Profit after commission
Now here's where it gets interesting:
$32 credit was received with a $200 margin requirement. So, only $168 is truly at risk (we got paid $32 to risk $200).
Therefore, the true return for the trade (known as ROI) is: 10.1% (see the calculation steps below)
$200 margin - $32 credit received = $168 truly at risk
$32 credit received - $15 commission = $17 net credit after commission
$17 net credit after commission / $168 truly at risk = 10.1%
Net Profit Percentage / ROI = 10.1%
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Comments
Thank you Trevor
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