Return on capital when trading options is different than return on capital when managing investments. Here’s what return on capital means to an options trader.
The nerd-speak of options trading means every moving part of your trading life has a handy phrase to describe it. Naturally, you trade with the intent to make a profit. So “return on capital” (ROC) is the technical phrase that describes the yacht you one day hope to buy from all your hard work. But let’s take a deeper look at this term.
Naturally, you enter a trade with the idea of making a return. It may not always work out that way. But you consider your capital investment and the trade’s maximum (max) profit potential. These two pieces of data comprise ROC. To wit: ROC = max profit ÷ capital used (buying power reduction).
ROC gives you the percentage return if your position makes max profit at expiration. If your position loses money, or the profit is less than max—such as if you close out the position before expiration—you’re not necessarily going to make that percentage return. That’s why ROC doesn’t measure your profit. Instead, it’s a tool that lets you compare two strategies to gauge how efficiently your capital is being used.
Say you compare two out-of-the-money (OTM) puts on the same stock with adjacent strike prices. The ROC of these puts lets you compare the potential return for a given probability. So even though the probability of profit (POP) may be higher for the further OTM put, the ROC might be lower.
Likewise, an undefined-risk strategy (versus a defined-risk strategy) will likely have a higher POP. But keep in mind: that undefined-risk strategy could have a lower ROC. Usually, the POP and ROC are related inversely.
To see ROC on the thinkorswim® platform from TD Ameritrade, from the Trade page, bring up the options chain. Click on the columns and select Layout. From the dropdown menu, choose Customize, and add “Return on Capital” for one of the columns. The ROC value on your platform takes the midprice of the option or vertical and divides it by the capital required to take the position. (To learn more about capital requirements for positions, read this Margin Handbook.
If you compare the ROC of single options and verticals, you may find the ROC on the verticals is higher. That doesn’t necessarily mean the spread is a better trade than the single option. It just means that given the amount of capital investment, that’s the ROC you could potentially make if you’re right.
In a small account where you may want diversification across several positions, ROC can illustrate how defined-risk strategies aren’t something to shy away from. Use this tool to compare similar strategies like a naked option to a vertical, or a straddle to an iron condor. Which one gives you the best possible bang for your buck?