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:
Contracts
Traded |
Fee/shr
to Buy |
Fee/shr
to Sell |
Total
Fees/shr |
Net
Profit/shr |
Return
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
Previous Section: Profitable Option Investing
|
