Question: How can you gain a better understanding of the risk/reward potential of an options position?
Answer: Profit/loss tables and risk graphs can provide visuals
We have all heard the adage, “A picture is worth a thousand words.” In the options market, the saying certainly holds true. To be specific, traders often draw risk graphs to provide a visual presentation of the potential risks and rewards of an option trade. These graphs, or “curves,” can greatly simplify the process of viewing possible outcomes from simple and advanced options strategies. Several factors can influence the price of an options contract. Examples include the time left until expiration and changes in volatility. The most important factor that affects options premiums is movement in the underlying asset. We know, for example, that if the price of the S&P 500 moves higher, calls on the index will increase in value and puts will lose value.
There are rare exceptions to this rule, but, in most cases, it holds true. What happens if we buy puts and calls?
For example, if the S&P 500 Index is trading near 1,530 and we buy the July 1550 call for $22.50 per contract and the July 1510 put for $18.50 per contract, we have created a “strangle” on the index. The cost of the trade is $41.00, $18.50 for the put and $22.50 for the call. What happens if the index moves higher or lower?
One method of viewing the potential profit or loss from an options trade like a strangle is to create a table and look at the value of the options contract at expiration. The table above shows some potential moves in the S&P 500 and the aforementioned July 1550 call and 1510 put. If at expiration the S&P 500 is trading at 1,600, the July 1550 calls are worth $50. Consequently, the strangle yields a profit of $9. On the other hand, if the index falls to 1,450 by July expiration, the 1510 puts are worth $60 a contract (1510 – 1450) and the trade shows a $19.00 profit. Obviously a strangle is more a volatility than directional bet, but knowing these potential outcomes helps in framing a trade.
The breakeven point is computed as the strike price of the put minus the cost of the strangle and the strike price of the call plus the cost of the strangle. In this example, the upside breakeven is 1,591 and the downside breakeven is 1,469 (see the table below).
SPX atJulyJulyCost ofProfit/
Expiration1550 Call1510 PutStrangleLoss
If the S&P is anywhere between the two breakevens, the trade shows a loss. For example, at 1,475, the call expires worthless and the put is worth $35.00 (1,510 minus 1,475). The loss (excluding commissions) is equal to the cost of the strangle minus the value of the put, or $6.00 (41 minus $35).
A second way to see the potential profit or loss from an option trade is with a risk graph. “A picture lasts longer,” plots the profit from the strangle along with the price of the S&P 500 Index. The solid black line is essentially the same information as in our table. It shows the profit and loss of the trade at expiration and confirms that the breakevens (blue horizontal lines) are around 1,590 and 1,470. Moreover, the risk graph has an important advantage versus the table format. It also graphs the risk-reward of the strangle prior to expiration.
For example, the first curve (red line) shows the potential profit or loss with 57 days left until expiration. Notice that if the S&P 500 moves quickly, the profits develop much faster. This is due to the effect of time decay on the puts and calls during the life of the strangle.
Risk graphs give options traders a snapshot view of the potential risk and rewards of various strategies. When creating complex trades with more than one contract, the graphs greatly simplify the process of creating and analyzing trades. They give the option strategist a better idea of the profit and loss potential, not just at expiration, but also as the options lose value through time. Today’s advanced software packages makes the process of creating risk graphs quick and easy.
Frederic Ruffy is senior writer and trading strategist for Optionetics. He can be reached on his message board at www.optionetics.com.