Consider the following theoretical example: - stock price is around $100 - market price of put option on the stock is $10 - the true value of the put option is $15, so you consistently buy the option, delta-hedge using the stock and come out with an average profit of $5. Let's say these are yearly options so we don't have to think about annualizing the PNL and all. Question is, what is your return? a) 50% per year since you make $5 on every $10 invested to buy the option. b) Since you need to delta-hedge, you need to buy the stock in variable quantities but overall you need $100 to buy stock with them. So you make $5 on approximately $100, therefore your return on capital is just 5%. c) $10 is your own money and $100 are borrowed money (from the bank or broker). Since this is a safe bet (arbitrage) you are sure to come out ahead by $5, so you borrow the $100, use them for a year, make $5 and return them to the bank (with interest). If interest rate were 0 (as it used to be), you'd be making 50% per year. But nowadays at 5% interest you're barely breaking even.
ROI = profit divided by margin (option margin + equity margin)(broker margins are different so...) ***Each option represents 100 shares so $100 won't be enough margin for the equity. If you needed to buy the full 100 shares x $100 = $10,000 x 50% margin for equity = $5,000. ***You can only capture the extrinsic value of an option by shorting it, not buying it. Time decay will get the option to intrinsic value at expiration so the long holder will lose the value and short holder will gain the decayed value. ***On a $100 stock, the 115 Put has a "true value" (intrinsic value) of 15. There's no way to buy it for 10 unless it's OTM (less than 100 on a $100 stock) in which case it has an intrinsic value of ZERO. ***Much less confusing if you use the Call side which will give the same result.
Simple % diff math:- Account value is X before trade is initiated. Account value is X + Y after trade is completed. X + Y / X = percentage difference (gain/Loss)
Well exactly my question: how much is "X"? Depending how you look at it it can be $10 bucks, $110 bucks or even ... zero. The whole "arbitrage" concept is built around making money out of thin air: enter broke and exit wealthy. Otherwise said, borrow $110 bucks, make $115, return $110.5 or so (negligible, near-zero interest rate) and voilà: made $5 bucks with starting X = 0. What's the %return in this case? Infinite?
No, that's not what I said. Theoretical example Account balance before trade is entered $10,000 Account balance after trade exited is $10,100 $10,000 / $10,100 = 1%
This is not a good example because there's a lot of money being unused. You're not supposed to compute "return on capital" on "capital that's just laying around unused". I could have 1 million in my account, if I use 1 dollar and make 2, that's 100% return on capital, not 0,0001%.