Wednesday, December 23, 2015

Reading a Risk Graph

OptionsAnalysis is a great tool to help you visualize risk in any stock and option position. The software can help you with something as simple as a call option to a multi-legged option and stock strategy. See my Tools page for more information.

As with anything, understanding and interpreting what you are looking at it key. In this post, I am going over how to read the position risk graph that is generated by this software.

Figure 1. Risk Graph
The first thing to notice about this graph is the shape. Look at three black lines - a bottom line which is slightly angled, an upward sloping line, and a top line again slightly angled. For this article, I am going to ignore the slight angle of the lines and assume they are straight.

This graph represents a collar position (stock + options) which is the same synthetically as a vertical spread. If you don't know what those mean, that's okay, because this post is about how to read profit and loss lines rather than the actual strategy itself. That's for another post.

Along the bottom there is the stock price divided into intervals of $5. Along the vertical there is a profit scale. This will vary depending on the size of the position. In this case, it is in units of $500.

So far so good. In addition to the black lines, there are three colored lines. The red line represents the position right now, the current date. The blue and green lines are the value of the position 30% and 60% later down the road. Because we are using options and options eventually expire, these lines are drawn to show values as the options get closer to expiration.

The point at the red arrow is the maximum profit of this vertical spread. No matter what happens, by expiration (after all the time value has gone), if the price reaches this point, this structure cannot be worth anymore. For this particular case, at $125/share, this trade has reached its maximum value. You would need to wait until nearly expiration to realize this.

The lower point on the graph at $115 defines the maximum loss for this position. In other words, no matter what happens to price, below 115, the position can loose no more than about $750.

This is the power of options. You define your price range and your reward and risk is both capped.

If your not clear on the importance of this, consider the following: this structure represents about $80K USD of stock value. I know that for the next 21d, how much I can make and how much I can lose. No matter what happens to this stock, I know my risk.

Can you say that of your money, wherever it is invested?
If not, subscribe and learn to hedge.

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