Change in Profit Calculations
As my trading evolves so does my knowledge and techniques. One thing that has been bothering me was the way we were calculating profits. Here’s why:
My basic philosophy is to be long a deep in the money call or put with several months of time. Each month I would sell front month time against that position to bring in monthly income and reduce my cost basis.
If I’m long a call for a debit of -10.00 and I bring in +2.00 a month in income that’s good. That’s a 20% return. However, if I bring in +2.00 but my long position loses -1.00 I’m only actually returning +10%. I don’t think I’ve been reflecting that in my profit calculations correctly.
Does that make sense?
What to do? Here’s my thought. Instead of just looking at the income over the risk to calculate the ROI we will create two measures.
1) We will measure the income over the risk and call that the ‘yield‘.
2) Once we close the trade we will measure the debit or credit to close against the cost basis. This will give us the total profit or loss in the trade over its entire time period and we will call this the ‘total return‘.
Here’s an example:
Let’s say its Jan 1st and we open an SPY 150 put calendar for a debit of -5.00. We are long the Jun 150s (-5.75) and short the Jan 150s (+.75). Our pre-roll cost basis is -5.75 and post-roll cost basis is -5.00.
In January once we roll the Jan 150s into the Feb 150s we book the credit from the Jan short (+.75) and calculate the yield. That means our yield for January was +.75 (income) /-5.75 (pre-roll risk) = +13%. We’ve generated an additional credit of +1.10 for rolling the Jan 150s to the Feb 150s. This gives us a pre-roll cost basis of -5.00 and a post-roll cost basis of -3.90.
In February once we roll the Feb 150s to the Mar 150s we book the credit from the Feb short (+1.10) and calculate the yield. That means our yield for February was +1.10 (income) / -5.00 (pre-roll risk) = +22%. We’ve generated an additional credit of +1.00 for rolling the Feb 150s to the Mar 150s. This gives us a new pre-roll cost basis of -3.90 and a post-roll cost basis of -2.90.
In March once we roll the Mar 150s to the Apr 150s we book the credit from the Mar short (+1.00) and calculate the yield. That means our yield for March was +1.00 (income) / -3.90 = +26%. We’ve generated an additional credit of +1.20 for rolling the Mar 150s to the Apr 150s. This gives us a new pre-roll cost basis of -3.90 and a post-roll cost basis of -2.70.
OK, with me so far? Good.
So its early April and we decide that we are going to close this trade (say for instance because the SPY has recently rallied to 157 on huge volume).
Our post-roll cost basis is -2.70. We get this by calculating the original cost of the long Jun 150s -5.75 and subtracting each month’s income / credit to reach -2.70.
Now, if we close the trade (buy the short and sell the long) for a total credit of +6.00 we’ve made a profit of +3.30 (total credit - cost basis). In order to calculate the total return you would take your [(profit / post-roll cost basis) - 1]. In this case it would equal [(+3.30 / 2.70) -1] = 1.22 - 1 = 22%.
Did I make any sense of this?
Feel free to post any questions.
Mojo
