Tuesday, February 23, 2010

Utility of a Risk Graph

Yesterday's post asserted that most experienced option traders have a dualistic approach when selecting strategies. That is to say they assess both their outlook on the stock as well as their outlook on volatility. The ideal outcome for all option trades occurs when both volatility and the stock move in the right direction.

Part of the learning curve with options is familiarizing yourself with the effect of volatility on individual option strategies. Performing "what-if" scenarios and stress testing your option positions is very easily done using risk graphs.

A risk graph is an analytical tool which gives a visual display of the risk-reward characteristics of option positions. Most risk graphs offer the ability to adjust various inputs such as time to expiration and volatility so that traders can model the effect these changes will have on their position. In addition to helping traders understand the influence of time and volatility, risk graphs can also aid in position sizing. Since they give us the ability to calculate how much a position will lose if things move adversely, we can determine how much is at risk in each trade. This in turn aids in determining how many contracts to enter in the position (click image to enlarge).
[Source: MachTrader]

Nowadays most online brokers tailoring toward option traders offer some type of risk graph within their tools. In addition to these brokerage firms, there are also other trading platforms offering option analytical tools. Regardless of what source you use, risk graphs certainly deserve a spot in every option traders toolbox.

8 comments:

Tim Justice said...

Great post Tyler....volatility is more important to me than charting as odd as that sounds.....thanks for filling in for my trading labs the students have been sending me positive feedback. I just put up a post on delta check it out!

Cheers,

Tim

http://tradingimagination.blogspot.com/

Anonymous said...

Hi Tyler,

SD will report its earnings February 25th after market close, the chart doesn't seem bullish to me, but I don't really know what will it happen.

So, maybe time for a straddle. It's not cheap, but it could be worthwhile. How can we build this straddle if it doesn't exist a strike ATM (strikes available 7.5 and 9, SD at 8) ?

Should we build a delta neutral position, for example: buy 2 PUT 7.5 and 1 CALL 9 ?

Thanks,
Siull

greg said...

One question I have about risk graphs is why each of the multicolored lines representing different time frames is different. If you could do a supplemental post explaining why the different time frames have different risk curves that would be really helpful for me.

Tyler Craig said...

Hey Tim,

Doesn't seem that odd if that's the variable you're seeking to exploit. Now if you couldn't neutralize delta at all, then I'd say perhaps it's worth paying a bit of attention to the chart. But, fact is you can to a certain extent so I'm with ya :) That's one of the reason the options mart is so dynamic. You got countless traders using options in a million different ways all at the same time.

I'll check out the post. Glad to have you back to blogging.

Tyler Craig said...

greg- will do. Look for a supplemental post in the next few days.

Tyler Craig said...

Siull- Thanks for the question. First off, what attracted you to SD for an earnings play? Anything in particular?

In my opinion not knowing what's going to happen is not a sufficient reason to consider purchasing a straddle. Heck, I never know what's going to happen into earnings, but that doesn't necessarily mean I buy straddles into every announcement. The only time it's justified to buy a straddle is if you think the options are under priced (i.e. the stock is going to move MORE than the straddle is pricing in).

If that's the case with SD, then sure you may consider buying a straddle. But don't do it if it's not.

Since the stock is at $8, you'd have to enter a strangle by purchasing the 7.5 call and 9 put. The put has a delta of 75 and the call has a delta of 70, so it's actually pretty close to delta neutral. If you wanted to get it to exactly zero, I would simply buy or sell shares of stock.

I suppose you could buy the 7.5 put and 9 call, but their so cheap it's probably just a lottery ticket.

Make sure you identify your break evens and are comfortable betting the stock is going to move up or down enough to make the trade profitable.

Anonymous said...

Thanks Tyler !

It was a bet, because I'd read in some forums that the company is undervalued and it could spike up, but the chart seemed bearish to me, so this play.

Certainly, the risk / profit potential doesn't attract me. But your answer has been useful as how to build a straddle when its not possible at ATM.

Cheers,
Siull

Tyler Craig said...

Siull-

Glad I could help.