Understanding profit and loss percentages is a crucial skill for options traders. This ability is especially useful in option spread trades that have predefined risk and reward such as the vertical credit spread. The bottom line in trading credit spreads is to look for trades that have very high probabilities of success.
1. Record the premium received from the option you sell. You can find option premiums listed in option chains, which are tables of options prices. These appear on various websites that track the financial markets. Each stock option represents 100 shares, so you need to multiply the premium listed in the option chain by 100 to get the dollar value. For example, if the premium is listed as 1.01, the option is worth $101.
2. Record the premium paid for the option you intend to buy. Follow the same steps you used to calculate the value of the first option. You need to record the option premiums so that you can use them in further calculations to determine profit and loss percentages.
3. Calculate the difference between the premiums. For example, if you sell an option at a $101 premium and buy an option at a $38 premium, your net credit is $63 less trading fees. This is your maximum gain on the trade.
4. Subtract the net premium received from the difference in option strike prices. In this example, subtracting the net premium of $63 from the strike price difference of $250 yields a value of $187. This is your maximum loss on the trade. Note that you must multiply the strike price difference by 100 before doing this calculation.
5. Divide the net credit received by the value obtained in the previous step. In this case, $63 divided by $187 gives an answer of approximately .34. This means that the maximum profit on the trade is equal to 34% of the maximum loss. You could also divide $187 by $63 to get 2.97, showing that the maximum loss is equal to 297% of the maximum gain. This means that in order for you to break even, this trade needs to have a success rate of approximately 75%.
- Note that a vertical credit spread may result in a gain or loss somewhere in between maximum profit and loss.
- While credit spreads have limited risk, selling options outright often poses theoretically unlimited risk. Make sure you thoroughly understand how options work before making any option trades.
Items you will need
- Option chain
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