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Critical mass - (It takes money to make money)

The ability to make large trades is key to option profitability. Brokerage fees typically reduce the net profit by $.05 to $.15 a share, depending on the size and type of trade. Broker fees, as a percentage of your profit, go down as the size of your trade increases.

Consider the below Bull Put Spread trade for ABC ($28.50)
Buy Put ABC ($24 strike expiring in 45 days) for $.20
Sell Put ABC ($26 strike expiring in 45 days) for $.45

The maximum profit for this trade is $.25 per share ($.45-$.20).
The amount risked is $1.75 per share (($26-$24)-($.45-$.20)).
If brokerage fees are $30 for the first contract and $2 per additional contract:

to Buy
to Sell
on Risk
1 $.300 $.300 $.60 -$.35 -20%
5 $.075 $.075 $.15 $.10 6%
10 $.050 $.050 $.10 $.15 9%
50 $.025 $.025 $.05 $.20 11%

The small investor loses money. The mid-size investor pays half the profit to the broker. The larger investor pays 20% of the profit to the broker. Usually the larger investor is also charged on a discounted rate schedule, so the disparity is actually larger.

The number of investors using options is rapidly increasing and brokerages are competing for business by offering discounted trading fees. As you see from the above example it pays to shop for a good commission deal.

The power of leverage

The above spread investment demonstrates the advantage and leverage that option investing provides. At 50 contracts, the investment immediately puts $1000 in your pocket and pays 11% return on risk over a 45-day period. As long as the price of ABC does not fall more than 8.5% in the 45 days, you make an annualized return of over 85%. Other calculations often show probability of profit in the 90% range and "expected value" in your favor (these terms are explained later).

To succeed at option investing, your individual investments must be large enough so that brokerage commissions do not prevent you from making profits. However, the total percentage of your portfolio value committed to an individual investment needs to be small and governed by your risk management strategy. We believe that investment portfolios smaller than $50,000 would have difficulty profiting on options while meeting risk management requirements. We present a discussion of risk management and our calculation of this figure in the next section.

Next Section: Managing Risk

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