Options trading is a dynamic and exciting component of modern investing. Options traders typically use leverage to create unique opportunities for significant rewards and risks alike. An options trade is essentially the purchase of a contract that provides the investor with the option to buy or sell a specific asset at a predetermined time in the future for an agreed-upon price.
Because of the unique contractual nature of these trades, investors will often calculate the anticipated return on an options contract before initiating the transaction. Fortunately, learning how to identify and use the option return formula is relatively straightforward and can be accomplished using a few simple steps.
You can calculate the return on an options trade by first determining total profit or loss from the sale and then comparing this value to the initial purchase price.
The Basics of Options Trades
An options contract is commonly distinguished by the specific privileges it grants to the contract holder. For example, if an options contract provides the contract holder with the right to purchase an asset at a future date for a pre-determined price, this is commonly referred to as a "call option." Inversely, when an options contract grants an individual the right to sell an asset at a future date for a pre-determined price, this is referred to as a "put option."
Options contracts are bought and sold through the trading week through the major exchanges, one of the most popular being the Chicago Board Options Exchange. Options contracts can cover a variety of investment assets, ranging from securities to commodities. With that in mind, the chances are good that an investor will be able to find a market for their specific interest.
Options Trades and Premiums
The individual selling the options contract must be provided with some form of incentive to initiate the trade. Because of this, a premium, or additional fee, will be added to the contract price that the investor must pay. The value of the premium can fluctuate dramatically based on the amount of risk the writer of the contract is taking on when they sell to the investor.
Once the expiration date of the options contract is reached, the contract holder must choose to either exercise their rights or forfeit the privileges they have purchased. In the event that they choose not to exercise their rights, they will not receive a reimbursement of the premium.
Whether or not the contract holder will choose to exercise their rights primarily depends on whether or not the asset in question has reached the "strike price," or the specific value at which the contract will yield a profit for the investor. If the contract has not reached the strike price, there is no incentive for the investor to exercise their rights.
Exploring Option Profit Calculators
In order to calculate the return on an option, the investor will need to know the price they paid for the options contract, the current value of the asset in question and the number of contracts purchased. From here, the steps outlined will apply to both call and put options.
- As a first step, the investor should subtract the initial value of the asset in the contract from the current sale price of the asset. For example, if an individual paid $12 for the contract and they currently are able to sell the same asset for $20, the correct calculation would be: $20-$12 = $8.
- The next step involves multiplying this value by the total number of contracts purchased. So, if an investor had purchased 200 of these contracts, the calculation would be: 200 * $8 = $1,600.
- As a final step, subtract the total price of the premium paid for the contracts from the prior calculation. So, if an investor had paid $260 in premiums for these options contracts, the calculation would be: $1,600 - $260 = $1,340. This final sum represents the total profit/loss earned from the sale.
To convert this figure into a percentage value reflective of total return, divide the profit by the total purchase price of the asset, and then multiply the resulting figure by 100. So, the appropriate calculation for this example would be:
1,340 / (20*200) = 0.335 * 100 = 33.5 percent return.
- The steps outlined above are only necessary if you have exercised the option. If you elected not to exercise the option, all the money you paid to purchase the option registers as a loss, so your return is zero.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.