How To Calculate Profit And Loss In Option Trading

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How To Calculate Profit And Loss In Option Trading – Trading options can seem complicated, but there are tools that can simplify the effort. For example, software can handle the fairly complex math needed to calculate the actual value of an option. And a risk graph, often called a “profit/loss diagram,” provides an easy way to understand the future impact of any complex option or option position.

To successfully trade options, investors must have a thorough understanding of the potential profit and risk for any trade they are considering. Risk charts allow you to see your maximum profit potential as well as your areas of greatest risk in one visual.

How To Calculate Profit And Loss In Option Trading

How To Calculate Profit And Loss In Option Trading

The ability to read and understand risk charts is an important skill for anyone who wants to trade options.

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Let’s start with a simple graph of the risk of a long position in the underlying stock. say 100 shares of stock priced at $50 per share. With this position, you will make a profit of $100 for every dollar increase in the stock price above your cost basis. For every dollar below your value, you will lose $100. This risk/reward profile is easy to show in a table.

To visualize this profile, simply take the numbers from the table and plot them on the graph. The horizontal axis (x-axis) represents stock prices labeled in ascending order. The vertical axis (y-axis) represents the potential profit (and loss) numbers for this position. Here is the two-dimensional diagram that is produced.

To read the chart, simply look at the price of any stock along the horizontal axis, say $55, and then move straight up until you reach the blue profit/loss line. In this case, the dot is plotted at $500 on the vertical axis to the left. That means that at a share price of $55, you will have a profit of $500.

A risk graph allows you to understand a lot of information from a simple visual. For example, we know at a glance that the breakeven point is $50, the point where the profit/loss line crosses zero.

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The graph also immediately shows that when the stock price goes down, your losses get bigger and bigger until the stock price reaches zero where you lose all your money. On the upside, as the stock price rises, your profits continue to grow with theoretically unlimited profit potential.

The risk graph for options trades includes all the same aspects that were just covered. The vertical axis is profit/loss, while the horizontal axis shows the underlying stock prices. You just need to calculate the profit or loss at each price, place the corresponding point on the graph, and then draw a line to connect the points.

Unfortunately, when analyzing options, it’s so simple if you enter an option position on the day the option(s) expires. That’s when determining your potential profit or loss is simply a matter of comparing the strike price of the option(s) to the stock price.

How To Calculate Profit And Loss In Option Trading

But any time between the date the position is entered and expiration, there are factors other than the stock price that can greatly affect the value of the option.

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The important factor is time. In the stock example above, it doesn’t matter if the stock goes to $55 tomorrow or if a year from now, your profit will be $500 regardless of time. But the option is a useless asset. For each day that passes, one option costs a little less (all else being equal). That means the time element makes graphing the risk of any option position much more complex.

On a two-dimensional graph that displays an option position, there are usually several different lines, each representing the performance of your position at different forecast dates.

Here is a risk graph for a simple option position, a long call, to show how it differs from the risk graph we drew for the stock.

Buying this February 50 call from ABC Corp. gives you the right, but not the obligation, to buy the underlying stock at the $50 price by February 19, the expiration date. Let’s say after 60 days.

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A call option allows you to control the same 100 shares at a price significantly lower than the cost of buying the shares outright. In this case, you pay $2.30 per share for that right. So no matter how far the stock price falls, the maximum possible loss is only $230.

The above graph, with three different lines, shows the profit/loss on three different dates. The solid line shows the profit/loss of this position at expiration, 60 days from now (T+60). The dashed line in the middle shows the potential profit/loss of the position in the 30 days (T+30) between today and expiration. The top dotted line shows the potential profit or loss of today’s position (T+0).

Note the effect of time on position. The value of the option slowly decreases over time. Note also that this effect is not linear. With so much time left before the deadline, only a little is lost each day to the decay of time. As you get closer to expiration, this effect starts to accelerate (but at a different rate for each price).

How To Calculate Profit And Loss In Option Trading

Take a closer look at this time decay. Let’s say the stock price stays at $50 for the next 60 days. When you first buy an option, you start even (with zero profit or loss). After 30 days, halfway through the expiration date, you have a $55 loss. On the expiration date, if the stock is still $50, the option is worthless and you lose the entire $230.

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Watch the acceleration of time decay. you lose $55 in the first 30 days and $175 in the next 30 days. Several lines together graphically show the decay of accelerating time.

For any other day prior to expiration, we can only provide a probable or theoretical price for the option. This forecast is based not only on the combined factors of stock price and expiration, but also on volatility.

The difference between the option’s cost basis and that notional price is the potential profit or loss. Note strongly that the profit or loss shown in the option position risk graph is based on the theoretical prices and therefore the inputs used.

When assessing option trading risk, many traders, especially those new to options trading, tend to focus almost exclusively on the price of the underlying stock and the time remaining on the option.

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But anyone trading options should also always be aware of the current volatility before entering into any trade. To determine whether an option is currently cheap or expensive, look at its current implied volatility against both historical readings and your expectations for future implied volatility.

By showing the time effect in the previous example, we assumed that the current level of implied volatility will not change in the future. While this may be a reasonable assumption for some stocks, ignoring that volatility levels can change can cause you to seriously underestimate the risk associated with a potential trade. But how do you add a fourth dimension to a two-dimensional graph?

The short answer is you can’t. There are ways to create more complex graphs with three or more axes, but two-dimensional graphs have many advantages, the most important of which is that they are easy to remember and visualize later.

How To Calculate Profit And Loss In Option Trading

So it makes sense to stick with a traditional two-dimensional graph, and there are two ways to do this when solving the problem of adding a fourth dimension.

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The easiest way is to just enter a number for what the volatility will be in the future, and then see what happens to the position if that change in implied volatility occurs.

This solution gives you more flexibility, but the resulting graph will only be as accurate as your guess for future volatility. If the implied volatility turns out to be completely different than your initial guess, the predicted profit or loss for that position will also be significantly reduced.

Another disadvantage of valuation and input is that volatility still remains at a constant level. It’s better to see how gradual changes in volatility affect the position.

That is, we need a graphical representation of a position’s sensitivity to changes in volatility, similar to a graph that shows the effect of time on an option’s value. To do this, we use the same trick we used before: hold one of the variables constant, in this case time, not volatility.

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So far we’ve used simple strategies to chart risk, but now let’s look at a more complex long thraddle involving a call and a call on the same stock, both with the same strike and expiration month. This option strategy has an advantage, at least for us

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