Editor's note: In this week’s Swim LessonsSM column, Kevin Hincks previews the capabilities of the Risk Profile tool and how it can be used to visualize the profit and loss (P/L) on a potential position in different scenarios. To learn more about this topic, TD Ameritrade clients can join Swim LessonsSM in the thinkorswim platform on Wednesday April 5th at 10:30 AM CT for “Trading Volatility with VIX Options”.
If you were stranded on a deserted island and could pick three things with which to survive, what would you choose? Here’s what I’d pick: sunscreen, a bag of pretzel sticks, and the Risk Profile tool on the thinkorswim® platform from TD Ameritrade.
OK… so that might’ve been a bit of a stretch. However, when it comes to assessing risk on a potential position, the Risk Profile tool would make a valuable addition to any trader's survival kit.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
No Corkscrew, But Still Quite Useful
The Risk Profile tool can help investors visualize the potential profit/loss on a position. They can even adjust certain parameters such as: the price of the underlying, number of days until expiration, and changes in implied volatility, to see how it might affect the value of an option. Remember, though, it’s just a theoretical estimation.
To pull up the tool on thinkorswim®, click on the Analyze tab, and then Risk Profile. Next, you’ll want to add a simulated trade, which you can do by clicking on Add Simulated Trades, just to the left of the Risk Profile button.
As you type in a ticker, an options chain pops up. Notice how the Add Simulated Trade page looks and acts similar to the All Products page on the Trade tab? There’s a reason for that. This tool is most beneficial prior to placing a trade, when you’re assessing the risk of a potential position. Now, once you choose an option and a strategy, click Risk Profile, and there it is in all its visual glory. For example, figure 1 shows the risk profile of a long 110-strike call option in a sample stock.
The Tool Explained, From (A) to (H)
Figure 1 shows the risk profile of a 110-strike call that was bought for $4.90 (times the options multiplier of 100 equals $490 per contract, plus transaction costs), and expires on May 20th. Across the bottom of the graph is the price of the underlying (A). The left side shows dollar amounts for profit or loss (B). Each underlying price corresponds to a profit or loss as shown by the lines on the graph (C).
This graph has two lines: a curved pink line and an angled blue line. The pink line represents the current date (April 2, 2017 in figure 1). The angled blue line shows the P/L at expiration (May 20, 2017). In the platform, when you hover your cursor anywhere on the graph, the corresponding P/L shows in the bottom left corner (D).
For example, if the underlying stock were to reach $117 on the date in figure 1, the trade is projected to make about $268, excluding transaction costs. This estimate changes to $211 if the position is held until expiration.
If the underlying stock were to drop to $107, on the current date, the trade would have a theoretical loss of about $340. At expiration, a price of $107 in the underlying would result in a loss of the entire premium paid, $490, plus transaction costs.
The short red vertical mark on each line (E) represents the breakeven point based on the time to expiration.
That light grey shaded area isn’t a mirage. It represents the potential range of the underlying between today and expiration, based on a one-standard deviation move in the underlying. (A good rule of thumb is that, about 68% of the time, a stock is expected to be within one standard deviation of the current price.)
You can change the grey shaded area to show a higher or lower probable range (F), and you can also change the date on which it’s calculated (G).
Following The Tides With Risk Profile
Want to see the risk profile on other dates prior to expiration, or at other levels of volatility? The Lines and Step buttons can help.
To see the potential effects of time decay on your trade, click on the Lines button (H) and change it to “+3 @ Day Step” and to the right of that change Step to 7, for example. Now you have three more curved lines, each 7 days apart, as shown in figure 2. Now you can estimate the potential P/L of your trade, based not only on the price of the underlying, but also with the passing of time.
Want to see how a trade might fare with changes to implied volatility? Click on Lines again and change it to Vol Step, choosing from 1-4 lines, and in Step select the change in the implied volatility you’d like to preview. For instance, with +3 lines at a step of +5% you’ll see the effects of implied volatility jumping 5%, 10% and 15%.
Understanding the Risk Profile tool—way more powerful than knowing how to crack open a coconut.
Swim LessonsSM: Live Trading Education
Are you a TD Ameritrade client and want to learn more about the Risk Profile tool and see it in action? Join Swim LessonsSM on Wednesday, April 12 at 10:30 AM CT for a special episode on “Building Your Strategy With Risk Profile”, in the desktop thinkorswim® platform, and on TD Ameritrade Mobile Trader
On desktop, TD Ameritrade clients can join Swim LessonsSM by launching thinkorswim®, and navigating to Support/Chat > Chat Rooms > Swim Lessons > Watch.
On mobile devices, TD Ameritrade clients can join Swim LessonsSM on mobile devices by launching the TD Ameritrade Mobile Trader® app and navigating to More > Chat Rooms > Swim Lessons > Watch.
Not a TD Ameritrade client? You can watch Swim LessonsSM live by registering for a free, 60-day trial of thinkorswim paperMoney®.
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