When traders make trading plans, they may include a desire to make 5, 10 or even 15 or 20 percent profits. But what's that profit based on?
While some traders calculate the profit based on either the debit spent or the credit received when the trade was initiated, others think they need a different measure. They want to know the profit based on the actual monies withheld by the brokerage while the trade is in effect. If that's the money that's tied up, then they want to know they made their desired profit on those tied-up funds.
Let's look at some examples. Imagine that a trader spent $529.30, including commissions, buying a single contract of a long IBM put or call. Since commissions were included, that debit would be the total buying-power effect on the trading account.
That trader would have a fairly easy time calculating what constituted a 10 percent profit on the original debit and buying-power effect. If that trader's commission structure was $2.95 per contract per trade, for example, a 10 percent profit would require that the option's value climb to $529.30 (with the 100 multiplier already applied) + $52.93 (a 10 percent profit) + $2.95 (cost to close the trade) = $585.18.
If you're using a trading platform that automatically keeps tabs on the profit or loss on a position, remember that figure most likely doesn't include the commissions you'll spend to exit the trade. I don't know of any live trading platforms that would automatically add in such a calculation, although I can't be sure they don't exist. However, in that last calculation and in all the others in this article, I will add in the commissions that would be needed to close the trade. I imagine that many of you do that, too. Depending on how many contracts there might be and how many legs, it's obvious that commissions can make a big difference. Of course, I'm using a hypothetical commission structure, one that may be higher or lower than your commission structure. With that addition made, I would know where to place a profit limit order to automatically collect the profit I want.
What if a trader employs a more complex options strategy that also results in $529.30 in margin or buying-power withheld? Is the calculation to find a 10 percent profit always the same for the same buying-power effect? For example, imagine that on October 26, with 26 days left until November's expiration and with IBM at 120.28, a trader sold an IBM iron butterfly with the sold call and put at 120 and with the long call and put at 130 and 120, respectively. [Obviously, with many days since having passed since this position was priced, this is not a trade recommendation, but rather an example for the purposes of calculating profits.]
With $2.95 per contract input as the commission cost, the position is set up as follow on a strategy summary. [Note: the blue background is the lightest background color available on this strategy summary for the software I use.]
The theoretical credit for the position would be $482.50, but the theoretical "investment" or buying-power effect would be $529.30, the same number withheld for that theoretical long option purchase already discussed. The wings are 10 points apart, and a $2.95 commission was charged for each of the four options that comprise this position. That makes the calculation for the buying-power effect $10-point wings x 100 multiplier - $482.50 credit + 4($2.95) commissions = $529.30.
We have that same buying-power effect as with the theoretical long call or put purchase. To make a 10 percent profit on that IBM butterfly, we need to collect $52.93 + 4($2.95) = $64.73 in profit. Remember, this time, our hypothetical trader has four options to close, so that $2.95 commission will be multiplied by 4. We can look at the strategy summary seen above or even a theoretical profit/loss graph and see that it is possible for the theoretical trader to collect that desired 10 percent profit, and more.
When the trader was figuring out the point at which the long put or call would provide that much profit, the calculated figure plus commissions was just tacked onto the purchase price. The long call or put would need to be valued at that level to provide the needed profit. Does the trader again tack the 10 percent profit plus commission cost ($64.73, in this case) onto the $529.30 buying-power effect to determine the point at which that 10 percent profit would be available?
No. This time, our theoretical trader collected a credit for the iron butterfly, with the iron butterfly being sold. Regular butterflies are different, of course, requiring a debit. In order to collect that 10 percent profit on the buying-power effect of $529.30, that iron-butterfly trader has to be able to buy-to-close the iron butterfly for $64.73 less than the original $482.50. That means the trader has to be able to buy-to-close the iron butterfly for $482.50 - $64.73 = $417.77 or $4.17 per contract or less. [We're rounding down this time because to pay $4.18 would collect less than 10 percent.]
This calculation may seem a bit confusing, so let's try it out from a different angle. Let's see if this calculation works to provide the desired 10 percent profit on the buying-power effect. If the trader bought the iron butterfly back at $4.17 per contract, the trader would pay a $417.00 debit plus $11.80 in commissions, so would pay a total of $428.80. The trader originally collected $482.50. The raw profit would be $482.50 - $428.80 = $53.70. That's $53.70/$529.30 = 0.101 or 10.1 percent. Remember that $529.30 was the buying-power effect of the iron butterfly. The desired 10 percent profit on the buying-power effect was collected.
The point is that when one calculates profits, many traders calculate those profits against the buying power or margin withheld by the brokerage. Once that calculation is made, however, the rest of the calculations may differ according to the strategy. This isn't the only way to calculate profits, but this is the way to determine whether you're making the desired profit on the actual money that is withheld from your account during the duration of the trade.