Calculating the Value of an Options Trade

I’ve found that it is sometimes difficult to “see” the value of an options trade. The reason is simple – premiums compound *when* they are taken. That is, a premium earned quickly compounds much faster than the same percentage over the long haul.

So, for instance, I entered a trade to sell a PUT option on MNK with a strike of $18.50 at $0.25 for a close date of June 29 – 3 days away! Now, first of all, my cardinal rule is that I would only sell a PUT with a stock that I don’t mind owning. That’s rule #1 (unfortunately, exercise fees on Ameritrade are $20, so that’s kind of expensive, but we’ll let that go for now).

Now, $0.25 doesn’t seem like a lot, especially since it is only a tiny return (after fees, it winds up being only 0.93%). However, for 3 days, that’s a lot! Now, you might try to do a simple multiplication to find out what that is worth over the year. You might think that, since there are 365 days in a year, 1% for 3 days will yield 120% averaged for the year, but you would be wrong!

The reason for this is that you have forgotten compounding periods. Because you get the premium money *now*, the compounding period is only 3 days. Compounded over a year, this is:

((1 + r)^n – 1)

Where r is your total return for the trade (0.0093), and n is the number of compounding periods (121 in this case). Therefore, the return that I will get is (1.0093^121 – 1) = 2.06 = 206% annualized return!

The method I have been following for finding premiums is this:

  1. Search for the best short-term (within the next weeks or months) out-of-the-money puts.
  2. Screen the list for companies you wouldn’t mind owning. Check the fundamentals, and see if likes it.
  3. Use these calculations to find the best option to sell.
  4. Don’t use margin. Make sure you have the cash to cover anything put to you!
  5. Also remember to factor in your “friction” – the amount that your trading platform will charge you. If you are doing small trades, this can be very difficult, and you may wind up having to sacrifice some of these principles just to avoid friction issues.

To find the “r” in the above formula, I am using this formula:

r = (p * c * 100 – f) / (s * c * 100)

where p is the premium, c is the # of contracts, f is your “friction” (cost of using the trading platform), and s is the strike price. To be super-conservative, you might add in the “exercise” price to “f”. Right now, using Ameritrade, f is calculated as

f = 6.95 + c * 0.75

And, if I was including the exercise price, I would add another $20 to f. This makes a huge difference in small trades, but not much difference in large ones.

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