As you may know, exchange traded funds (ETFs) exist for our big indexes the S&P500 (ETF symbol: SPY) and the Russell2000 Index (ETF symbol: IWM).

If we believe that both will fall and we want to do a call spread strategy to bet that each won’t go above a certain level — but we only have limited capital, which ETF should we execute the short call spread on — given that we believe each will fall with the same probability and by the same percentage amount?

Well, to figure that out, we would want to know what is the max profit we can get —the net credit received — from the trade compared to how much margin we need to put up.

To demonstrate, we have below screenshots from the mobile app trade screen where we can see how much extra margin this trade would take at the bottom — circled below.

Here’s what we found:

If SPY is trading slightly below our 210 call strike price — here’s what the calculations look like:

**Credit Received:** $825 USD

**Margin Required/Eaten Up:** $4,500

**Return on Margin:** 18.33%

**Return on Capital:** 36.67%

Keep in mind we inadvertently entered 10 contracts into the app prior to taking this screenshot so the numbers look a bit big. If we were to divide everything by 10 so we can just see the numbers for 1 contract, the numbers would look like this:

**Credit Received:** $82.5 USD

**Margin Required/Eaten Up:** $40

**Return on Margin:** 18.33%

**Return on Capital:** 36.67%

So percentage return on margin remains the same at 18.33%

It means that your account needs to have $4,500 in there in order to execute this trade. If the trade works out (expires below our strike price of $210 SPY by expiration) — then we get to keep that $825.

Since we required $4,500 to do this trade and we received $825 in a successful trade, then the return on margin is simply $825 / $4,500 = 18.33% (close to 20%) return on margin.

So if SPY gives us an 18.33% return on margin, then what is the return on capital?

Typical margin accounts give you a 2:1 leverage, so that $4,500 that we put up before? Well, actually, that’s effectively $2,250 of our actual cash. So the return on capital calculation is actually $825 / $2,250 = 36.67% return on capital.

That’s a pretty healthy return on capital.

If IWM is trading slightly below our short strike of 118.5 call – here’s what the calculations look like:

**Credit Received:** $42 USD

**Margin Required/Eaten Up:** $350

**Return on Margin:** 12%

**Return on Capital:** 24%

It means that your trading account needs $350 in margin for each pair of call spread contracts you intend to trade — each one giving you $42.

If you had 10 call spreads, that would require $3,500 in margin and give you a potential credit of $420.

The return on margin is calculated by taking the potential credit/profit of $42 and dividing it by $350 = $42 / $350 = 12% return on margin

Return on capital (assuming a typical 2:1 leveraged margin account) would calculate based off of half the margin — so half of $350 = $175. And the profit divided by capital would be $42 / $175 = 24% return on capital.

SPY call spread %return on margin > IWM call spread % return on margin

By how much? By about 50% better (12% for IWM vs 18.33% for SPY)

While these are not exactly perfect apples to apples comparisons –the general idea is that the return on margin for a call spread trade on SPY is a bit more efficient (20% return on margin) than the same trade on IWM (12% return on margin).

So if you are running low on margin and you have believe you have equal probability of success on betting that the IWM won’t go above a certain point and SPY won’t go above a certain comparable point, then it is generally a smarter use of your margin to choose the SPY trade over the IWM trade.

But you believe IWM has a higher probability of staying below the short strike than the corresponding SPY — then you should trade the IWM — always focus on higher probability first.

SilverSurfer is a former hedge fund derivatives trader at a Wall Street Investment Bank (Prop Trading Desk) and has been trading the markets since 2002.
He received a B.S. in Management Science from Stanford University with a focus on Finance and Decision engineering. He was actually in the audience during Steve Jobs' now famous graduation speech. This trading education blog is partly a result of the inspiration from that speech.
Here at LifeStyleTrading101, Mr. SilverSurfer serves as Head Trader sharing not only his market views and trades publicly, but also his passion and vision to educate everyday people with real-life practical skills in how to make a little extra money in the global financial markets.
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