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Trading options for income: Capital efficiency

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In our quest to understand trading options for income, we often consider how we can use our capital at risk more efficiently. A common metric is ROC (return on capital), and by converting ROC to a daily value we can use this figure as a measure of efficiency for comparing various strategies.

ROC is computed by taking the expected profit and dividing it by the cost (the capital at risk) of the option strategy; it's expressed as a percentage. When selling options (iron condor or strangle), the premium received is the profit, and the BPR (buying power reduction or margin requirement) is the capital at risk. The equation is: ROC = Premium / BPR.

To convert ROC to a daily rate, we simply divide ROC by the option's DTE (days till expiration), or the actual holding period. The equation is: ROC Rate = ROC / DTE.

Recently a contributor to Tasty Trade ran a test on the SPX, /ES and /CL (crude oil) using two option strategies: an IC (iron condor) and Strangle. The short strikes for each leg were placed at 95 percent OTM (out of the money) for a POP (probability of profit) of 90 percent. The width of each IC leg varied from 20 points to 100 points. The DTE varied from 47 days (Monthly) to 6 days (Weekly), and profits for the Monthly were taken at 50% of premium and full premium (expiration). The test was run on May 3, 2014, when the SPX IV Rank was 17.

The results: for the SPX and /ES, only the 20 point wide IC strategy was used because the very high BPR (around $30k) of the Strangle makes it impossible for small accounts to trade. For the SPX, the most efficient performer was the 6 DTE with an ROC Rate 0.84% (ROC 5.0%) vs. 47 DTE (50%, duration of 13 days) with an ROC Rate 0.20% (ROC 2.6%) vs. 20 DTE (50%, duration of 8 days) with an ROC Rate 0.21% (ROC 1.7%). The 20 point wide /ES 6 DTE came in with a respectable ROC Rate 0.57% (ROC 3.4%).

However, the 45 DTE /CL Strangle (50%, duration of 28 days) ranked highest with an ROC Rate of 1.24% (ROC 34.8%) vs. 1 point wide 45 DTE /CL IC (50%, duration of 28 days) with an ROC Rate of 0.27% (ROC 7.6%).

In conclusion, it is no surprise (except perhaps to Tasty Trade) that the Weekly SPX (6 DTE) outperformed the Monthly both in ROC and ROC Rate by a wide margin. When looking at the premium, it was two to three times larger than the 47 DTE and 20 DTE Monthly. The /CL looks like a good choice, but there are problems with its options you need to be aware of: liquidity, settlement, and dividend risks. The futures contracts (the underlying for these options) are also more prone to manipulation.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.