We are going to alter the way in which we calculate the percentage return on our spread trades, where the spread involved being short one option and long another. The aim of this change is to give a fairer representation of returns.
The type of trade this affects the most is vertical spreads, where we received a net credit for placing the trade.
We will use the first trade of this type to demonstrate the differences in the methodology.
In this trade we sold a vertical put spread on GLD. We bought GLD Sep-10 $110 puts for $0.68 and sold GLD Sep-10 $111 puts for $0.80, gaining a net credit of $0.12. The spread expired worthless and we banked maximum profits on this trade.
Under the original method the profit would be calculated at 12%.
The figure was arrived at by taking into account that we made $0.12 by selling a $1 wide spread. If GLD was at $110 or less at expiration, then the difference in the value of the options (the spread) would be $1. Therefore $0.12/$1=12% profit.
The flaw in this method is that if GLD went to say $100 and we got the trade completely wrong, losing everything we possibly could, we would only show a 88% loss.
This would be calculated as follows: We sold the spread at $0.12 and it expired at $1, therefore we lost $0.88. Percentage loss = $0.88/$1 = 88%.
Under this method it is not possible to have a 100% loss under any scenario.
Under the net method the profit would be calculated at 13.64%.
The figure was arrived at by taking into account that we made $0.12 by selling a $1 wide spread, but the maximum we could lose was $0.88 since we got the $0.12 net credit for placing the trade. If GLD was at $110 or less at expiration, then the difference in the value of the options (the spread) would be $1. Therefore $0.12/($1-$0.12)= 13.64% profit.
The benefit of this method is that if GLD went to say $100 and we got the trade completely wrong, losing everything we possibly could, we now show a 100% loss.
This would be calculated as follows: We sold the spread at $0.12 and it expired at $1, therefore we lost $0.88. Percentage loss = $0.88/$0.88 = 100%.
In short, the original method understated our losses and understated our profits. Therefore we have opted to change the system and our reports accordingly.
Although this will increase our reported percentage gains for our winning trades, it will also increase our reported losses for our losing trades. For example previously we reported a 32% loss on selling a SLV vertical put spread $0.26 and buying it back at $0.60, but this will now be changed to a 46% loss as ($0.26 - $0.6) / ($1 - $0.26) = -46%.
We are not making this change to enhance the appearance of our trading record; we are changing the method as we do not think it is fair to use a method that does not allow for a 100% loss to be shown. We will happily provide both sets of figures on request. However, we will adopt this new method for the time being and continue to monitor it in order to ensure that it truly reflects our position.
The reason we had been using the original system was that we thought it better to err on the side of caution and over allocate capital to trades and report profits conservatively. However since this system is now causing us to understate losses we feel it is only fair that it be altered.
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