Return on Capital: What the Numbers Really Show

Key Concepts

Return on Capital (ROC): A trading metric calculated by dividing net profit or loss (P&L) by the required capital, represented by buying power reduction.
Buying Power Reduction: The amount of capital an options trade ties up, which varies based on account type (IRA, margin, portfolio margin) and the specific trade.
Portfolio Margin: A margin account type that allows for significantly less buying power reduction for certain trades, especially with larger account balances ($150k-$175k+) and uncorrelated positions.
Implied Volatility (IV): Market expectation of future price fluctuations, a key factor influencing option premiums.
VIX: The CBOE Volatility Index, a widely used measure of expected stock market volatility.
SPY Strangle: An options strategy involving selling an out-of-the-money call and an out-of-the-money put on the SPDR S&P 500 ETF Trust (SPY).
Delta: A measure of an option's price sensitivity to a $1 change in the underlying asset's price.
Premium: The price paid by the buyer of an option to the seller.
Win Rate: The percentage of trades that result in a profit.
Correlation: The statistical relationship between two variables, in this context, ROC and VIX.

Effectiveness of Return on Capital (ROC) as a Trading Indicator

The effectiveness of Return on Capital (ROC) as a trading indicator is presented as subjective and dependent on its proper application. While it's a calculated number, its interpretation requires context. The video emphasizes that ROC is most useful when used in conjunction with other market factors, particularly implied volatility.

ROC Calculation and Buying Power Reduction

ROC is defined as Net Profit/Loss (P&L) divided by the Required Capital, which is represented by the Buying Power Reduction. A crucial point is that Buying Power Reduction is not static; it varies significantly based on the account type:

IRA Accounts: Have different buying power rules.
Margin Accounts: Standard margin requirements apply.
Portfolio Margin Accounts: For accounts exceeding $150,000-$175,000, buying power reduction can be substantially lower, especially for trades with uncorrelated positions or those on instruments like SPX that may use minimal buying power.

This variability means the same trade can have different ROCs depending on the account structure.

ROC Thresholds and SPY Strangles

The discussion then delves into using ROC as an entry criterion for option strategies, specifically focusing on selling SPY strangles.

Current Example (4 days prior to transcript): A 45-day, one standard deviation SPY strangle had a max ROC of 8% with a premium of $847 and a buying power reduction of $9,500. This was considered a "decent" to "quite good" ROC, likely in a margin account.
Historical Analysis (2013-Present): A study of selling one standard deviation SPY 45-day strangles, managed at 21 days to expiration, revealed:
- Historical Average Max ROC: Approximately 6%.
- Historical Median Max ROC: Closer to 5.7%.
- Current Observation: The 8% ROC observed was significantly higher than the historical average and median.

This historical context is vital for determining if a current ROC is high or low. The video argues that when current ROC is significantly above the historical average (e.g., 8-9% vs. 6%), it indicates an opportune time to sell premium, especially during periods of elevated volatility.

ROC as an Entry Criterion

The video explores using a ROC threshold as an entry criterion, similar to using Implied Volatility Rank (IVR).

Methodology: Trades were initiated only when the potential max ROC exceeded the historical median (set at 6% for this analysis).
Findings:
- Higher P&L: Initiating trades when ROC was greater than 6% resulted in significantly higher P&L.
- Comparable Win Rate: Crucially, this higher P&L was achieved with a comparable win rate. This suggests that traders are getting paid more for the same risk when ROC is elevated.
- Impact of IV: The higher ROC and better performance are directly linked to higher implied volatility (IV). When IV is high, premiums are richer, creating more favorable conditions for premium sellers.
- VIX Levels: The analysis showed a strong correlation between VIX levels and average P&L. Higher VIX (e.g., 25) led to substantially higher average P&Ls ($110) compared to lower VIX (e.g., 15, $40). The current VIX of 21 placed the scenario in the middle, suggesting opportunities still exist.

Correlation Between ROC and VIX

A long-term perspective revealed that the max ROC of SPY strangles is "almost always positively correlated" with the VIX. The white areas in the accompanying graph represent instances of non-correlation, which are typically associated with small volatility moves. This strong correlation reinforces the idea that ROC serves as a useful indicator for market conditions, similar to trading entry signals.

Key Arguments and Perspectives

Embrace Volatility: The core argument is that traders should not shy away from volatility but rather embrace it to utilize capital efficiently. High implied volatility, which often leads to higher ROC, presents opportunities for premium sellers.
ROC is Not a True Driver: The video clarifies that ROC itself is not the primary driver of profitability. Instead, elevated implied volatility boosts both ROC and overall trade performance.
Premium Selling Advantage: When IV is high, premiums are richer, and conditions are more favorable for those selling options. This is where ROC can be a valuable indicator of these favorable conditions.
Consistency is Key: While catching the absolute top or bottom is impossible, consistent entry strategies based on indicators like ROC and IV can lead to capturing opportunities most of the time.

Data and Statistics Mentioned

Current ROC Example: 8% (4 days prior to transcript)
Historical Average Max ROC: 6%
Historical Median Max ROC: 5.7%
Win Rate Comparison: Comparable win rates observed for trades with ROC > 6% and ROC < 6%.
Average P&L Comparison (VIX 25 vs. 15): $110 vs. $40.
Current VIX: 21.

Step-by-Step Process (Implied Methodology)

Define ROC: Understand the calculation: Net P&L / Buying Power Reduction.
Assess Buying Power Reduction: Recognize its variability based on account type (IRA, Margin, Portfolio Margin).
Analyze Historical ROC: Study the historical average and median ROC for specific strategies (e.g., SPY strangles).
Establish a Threshold: Use the historical median (e.g., 6%) as a benchmark.
Use ROC as Entry Criterion: Initiate trades when the potential max ROC exceeds the historical threshold.
Monitor VIX and IV: Correlate ROC with VIX levels and implied volatility to understand the underlying market conditions.
Evaluate Trade Performance: Compare P&L and win rates for trades entered above and below the ROC threshold.

Notable Quotes

"I'm going to say it's kind of subject. I think it could be subjective. Again, it's a number. It's a calculation. So, I feel like it could probably be subjective. I think you got to use it in the right way." (Attributed to the speaker, discussing ROC's subjectivity).
"You don't run away from volatility, you embrace it in a way that you can, you know, not ramp up, but use your your capital in a in a efficient way." (Attributed to the speaker, advocating for embracing volatility).
"The big takeaway of the whole story here. um you know you don't have to work as hard and you make more money, right? I mean that's what we're what we're all looking for here." (Attributed to the speaker, summarizing the benefit of trading with elevated IV).
"ROC isn't a true driver. Elevated implied volatility boost both return on capital and performance." (Attributed to the speaker, clarifying the relationship between ROC and IV).

Conclusion

Return on Capital (ROC) is a valuable indicator for option traders, but its effectiveness hinges on understanding its calculation, the nuances of buying power reduction across different account types, and its correlation with implied volatility. The video strongly suggests that using ROC as an entry criterion, particularly by favoring trades with ROC above the historical median (around 6%), can lead to significantly higher profits without compromising win rates. This is primarily because elevated implied volatility, which drives higher ROC, provides richer premiums and more favorable conditions for premium sellers. The key takeaway is to embrace periods of high volatility, as indicated by higher ROC and VIX levels, to enhance trading performance.