Welcome back, Stock Traders!
As you remember from my last 3 posts, the return on investment or ROI can be much greater for stock options than trading traditional stocks.
How do you calculate your return on investment? This tool is useful not only if you are dealing with the stock market but in other investments as well. Read below to learn how.
Here’s the Formula
Here is the basic formula to figure out your return on investment (ROI):
ROI = (Net Profit / Total Investment) X 100
Net profit = total revenue after deducting all expenses and operating costs
Total investment = total money used to purchase your investment
ROI for Options
Let’s say that Joe is looking to invest in stock options for Z Bread company because he believes the stock price will go up to $10 or more in the next 30 days; Z Bread is currently trading at $100 per share.
Joe buys 2 call contracts of Z Bread that expire May 29th at a strike price of $110 with a premium of $5. Fifteen days later, Z Bread’s market price goes up to $125.
Joe’s current return on investment on this call option if he exercises the option now is:
Net Profit = [(Current Market Price – Strike Price) – Premium Cost] X # of Contracts X 100
$2K = [(125 – 110) – 5] X 2 X 100
Total Investment = (# of contracts X Cost of Premium X 100)
$1K = (2 X 5 X 100)
ROI = (2K / 1K) X 100
ROI = 200%
ROIs for Traditional Trading
Now let’s compare that to traditional trading.
Joe buys 200 shares directly of Z Bread at $100 per share. The stock goes up to $125.
Net Profit = (Current Market Price – Previously Purchased Price) X # of shares
= (125-100) X 200
$5K = 25 X 200
Total Investment = Previously Purchased Price X # of shares
$20K = 100 X 200
ROI = (5K / 20K) X100
ROI = 25%
Let’s compare this to more common transactions made by your average person.
Most people view their home as equity or something that will increase in value and make them money over time. Some may even flip houses for money. We will use the traditional example here.
Sara buys a house for $100K in 2005 and sells the same house ten years later for $130K. During this time, she makes routine maintenance repairs to the home that total $5K. Sara also has a 7-year mortgage that she paid $4K in interest on and is now paid off.
What is her return on investment?
ROI = [Net Profit (Gain in Investment – Cost of Investment) / Cost of Investment] X 100
Net Profit = $130K – (All Liabilities + Original Investment Cost)
Net Profit = 130K – (5K + 4K + 100K)
Net Profit = $21K
ROI = ($21K / $100K) X 100
ROI = 0.21 X 100
ROI = 21 %
There are usually more expenses with owning and selling a home so this percentage may be quite lower than some in reality. Many other factors can come into play that affects the return on investment, but I wanted to provide a rough, general reference.
The way the ROI is calculated may vary a bit depending on your trading strategies and use of either buy or selling puts or calls. Return on investment is important to compute to ensure you are making smart choices with your investments for your future. It is also an important step in figuring out your expenses so that you are aware of them and can keep them at a minimum if possible to increase your equity.
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