One of the most effective ways to maximize your investment returns is by trading options. Kim is an expert in this niche. Enjoy his guest post below and, once you’re ready to try option trading, consider signing up for TradeKing to get $100 in free trades. Now, onto his article!
There are a lot of ways that trading systems can inflate their performance. “Maximum profit potential”, “Cumulative return”, “90% winning ratio”, “Annualized return” are just few of the tricks used in the industry to entice you into joining their website. This article describes some of the tricks used to make performance numbers much better than they are.
Aggregate vs. ROI
When you start looking at the different ways in which trading results are analyzed, you’ll notice that they fall into two broad categories, Aggregate Analysis and Return on Investment analysis. Most trading systems use versions of Aggregate Analysis which is a slippery slope into results that are at best misleading, at worst, deceptive.
Let’s say, for example, that you did one trade in the month. They make 10% on that trade. According to Aggregate Analysis, you would then claim that they had made 10% for the month. But did you?
In another instance you did 4 trades for the month, averaging 10%. According to Aggregate Analysis, you made 10% for the month.
So all Aggregate Analysis does (and this is where its name comes from) is add the results of the individual trades together.
The problem is you haven’t actually made 10%. Not in the way that most people would think about trading or investment returns. 10% return assumes that you allocated your while account to that single trade – which of course is insane.
Let’s assume you have a bank of $10,000 and you’re risking 5% per trade because you’re trading options and options are risky. So that’s $500 maximum per trade. The trade makes 10% which is $50, so you’re out for $550.
What return did you make for the month?
$50 / $10,000 = 0.5%
No, you did not make $1,000, as the 10% return suggested you would. You only made 0.5% because, normally, returns are calculated based on the total investment. And your total investment wasn’t just the $500 you put at stake for that particular trade, it was the entire $10,000 you have in your trading account, because while it’s sitting there in your trading account it isn’t doing anything else. You can’t have it invested elsewhere earning money for you – it has to be in your trading account so you can practice proper money management and risk allocation.
Calculating gains based on cash and not on margin
This is one of the most outrageous frauds. This is how it works:
A risk reversal involves selling a put and using the proceeds to buy a call (or vise versa). Let’s say you buy a $18 call and sell a $18 put for a net cost of $0.04, and close the trade for $0.50. 1,150% gain? Not so fast. Selling naked put involves a margin of ~$450 per spread, so $46 gain is really 10% gain and not 1,150%.
Another example involves VIX calendar trades.
VIX calendar is not a “standard” calendar where the only capital requirement is the debit paid. Your risk is not similar to regular calendar spread. You may lose more than the debit you pay for. The reason is that VIX options are priced based on VIX futures, not VIX cash index.
Regular long calendar spreads don’t require margin. Your cost is the debit you pay. However, VIX calendar spreads requires margins. How to calculate margin requirement for VIX calendar spreads?
Margin requirement varies between brokers. I’m using IB (Interactive Brokers), and I believe they offer the most reasonable margin requirements: $150 per spread. Same requirement for put and call calendars and all strikes.
If you open a VIX calendar for 0.50 and close it for 1.50, what was your gain? 200%? Not really. Your capital requirement included $150 margin, so you basically opened it for $200 and closed for $300, for 50% gain.
There are a lot of trading systems which make only one trade per month (or per week), yet they present their results as “350% cumulative return since inception”. While technically this is correct, does it mean anything? Would you be comfortable placing your whole portfolio (or even half of it) into one weekly Iron Condor?
When you claim a 1,000% return for the year, wouldn’t you assume that if you started the year with $10,000 and invested in all the trades, they would now have $100,000? But this is not the case.
For instance, if you make 100 trades for the year and each trade made 10%, would you made 1000% for the year?
The problem is that the returns on trades that overlap cannot be added together. If you have 5 open positions and each position made 10%, did you make 50%? Of course not, because you could allocate only 20% to each position. So your overall return was 10%, not 50%.
Kim Klaiman is a full time Options Trader and founder of SteadyOptions.com – options education and trade ideas, earnings trades and non-directional options strategies. Read more from Kim on his Options Trading Blog and Options Trading Forum — and follow him on Twitter: @SteadyOptions.