Buying Power Reduction and the Risk-Return Tradeoff

As a small-account trader, there’s a lot of different things that I have to pay attention to when I place a trade. I’ve mentioned many of the different variables before (Greeks, IV, etc.), but ANOTHER one is the buying power reduction.

Buying power is the total capital available in our account. Buying power reduction is the amount of capital it takes to place a trade (aka the margin required).

You have to keep BPR in mind for many reasons. Number one, you want to place trades that don’t completely take over your account. It’s a lot better to have 6 little trades going, rather than one big one.

Furthermore, the more trades that you have going, the less probable it is that any one trade will wipe you out. But in the case that one trade does make a big downward swipe, you want to have enough capital available to remedy that- and you can only do that if you have enough buying power to make a countertrade.

When we place defined risk trades, the buying power reduction is the maximum loss we can experience. So if we sell a 3 point wide spread for $1, the max loss and the buying power reduction for that contract is $2.

Mathematically, the BPR/Max Loss = Width of the Spread – Credit Received

Pretty simple, right?

Not quite.

I tend to stick to defined risk trades, because I’m a bit of risk-averse investor. But people with larger accounts, or who are more risk-seeking, often undertake undefined risk trades. The BPR for those are a bit more complicated.

There are 3 different equations. We pick the one that generates the largest number.

  1. (20% of Stock Price – OTM Amount + Credit) x 100 x #Contracts
  2. (10% of Strike Price + Credit) x 100 x #Contracts
  3. ($50 x # of Contracts) + (Credit x 100 x #Contracts)

So, if we had COST (my fave-costco) trading for $168, and we sold one 165 put for $1 (assuming 1 contract):

  1. [(20% x 168) – (168-165) + 1] x 100 = $3,160
  2. [(10% x 165) + 1] x 100 = $1,750
  3. $50 x 1 + 1 x 100 = $5,100

Our BPR for selling a put in Costco is about $5,100.

For calls, one of the formulas differs, and only slightly. The second formula is (10% of Stock Price + Credit) x 100, rather than Strike Price.

For defined risk trades, BPR remains constant (thank goodness). For undefined risk, the BPR is dynamic, meaning that it responds to moves in the underlying.

Interestingly enough, the BPR increases as the stock moves to the upside, at about a 1.5 greater reduction than a same amount down move would generate.

So, if the stock price rises 15%, the buying power reduction would almost triple. So instead of a $5,100 BPR in Costco, we would have a $15,300 reduction. YIKES! A down move would be a double in BPR- so an increase to $10,200.

This smaller increase is because we technically have “limited losses” on the downside. The stock can only go as far as zero, and then we stop losing money. However, there is an unlimited upside- the stock can theoretically go to infinity, which is why an upmove is much riskier!

Okay, so how do we work around that?! Basically, the easiest thing to do is to place defined risk trades.

BUT

I’m not super knowledgeable on undefined risk trades, but I know the risk-return tradeoff is usually worth it. If your account can handle those BPR swings, taking those risks can definitely amount to some pretty nice profits.

Also, Costco is an expensive stock. XOP, priced at $45, has an average BPR of about $500 for shorting puts. The more expensive the stock, the greater the BPR

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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