Editor's note: In this week’s Swim LessonsSM column, Kevin Hincks previews how to stress-test your options strategy using the theoretical price tool in thinkorswim®. TD Ameritrade clients can join a LIVE Swim LessonsSM session on Stress Testing Options Strategies in the thinkorswim platform® on Thursday May 4th at 10:30 AM CT.
Conditional probability is the likelihood of one event occurring, given that a previous event has occurred. We might not realize it, but we use this logic each and every day.
- If I leave 15 minutes earlier, then it’s less likely I’ll be late.
- If I ask the waiter for extra cheese, extra sauce, and extra french fries, then I will most likely experience deep feelings of regret later on.
- If the stock that I own beats earnings, and if implied volatility decreases, then the value of my long call would likely equal "X."
While the thinkorswim® platform from TD Ameritrade can’t provide hypothetical probabilities for the first two scenarios, it can help you answer the last scenario. Here’s how.
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. Keep in mind that past performance of a security is not a guarantee of future performance or investing success.
Expecting a “One-and-Done” Move?
Often, when a company has a big news event, such as an earnings release or announcement of a new product or initiative, the company’s stock will have one big move, and then settle into a range. And if the news has removed a level of uncertainty, volatility may gap lower as well.
Let’s say you’re an options trader and you’re long a call option on a stock with an upcoming earnings release. You want to see how its theoretical value might change the day after earnings release, if the stock were to rally $3 and the implied volatility were to drop 3 percentage points.
Figure 1 shows you how to do this on the thinkorswim platform. Type in your stock symbol under the Trade tab, and change the Layout (1) to Theo Price, Mark. This will give you a column showing the theoretical price for each option in the chain (2).
To the right of the Layout button, notice the Theo Price button (3), which allows you to change the date, stock price and implied volatility. Click on any of these settings and you’ll be able to analyze different “what if” situations.
Suppose you own a June 50 call under the parameters shown in figure 1— the underlying stock is trading at $51.81, and the June 50 call is worth $3.57. Let’s say earnings are to be released May 2 (two days after the date shown in the options chain), and you’d like to assess the potential effect of a $3 rally in the stock, to $54.81, concurrent with a 3 percentage point drop in the call’s implied volatility.
Clicking on the Theo Price button will pull up a box that will let you stress-test, or “forward test” an option price. Figure 2 shows the hypothetical effect of a change in the date—May 3 in the example—which you can get by either typing in the date or by clicking on the up /down arrows to move the date forward or back. You can adjust the stock price and implied vol in similar fashion.
Assessing Theoretical Risk/Reward
As each change is entered, the theoretical price in the option chain reflects that change. With all three of our changes entered, we can see that the theoretical price of the June 50 call went from $3.57 to $5.46 (2). So, theoretically speaking, the rise in the stock price would be more than enough to cover a 3-point drop in the volatility the day after earnings. You should also stress-test your position with the stock moving against you, to estimate what kind of loss you might incur.
In fact, you might want to try a number of different scenarios in order to fully gauge the risk/reward of a position, especially if you think a big news event is imminent. (Please note that a long call option position places the entire cost of the option position at risk. Should the call expire worthless, the entire investment in the position would be lost.)
But remember: these are just estimates, based on theoretical pricing models, and what happens in the real world may differ. But this can be a great way to preview potential outcomes for your position based on changes in time, the price of the underlying, and implied volatility.
Want more on stress testing? Join Swim Lessons on May 10, 2017 at 10:30 AM CT as Scott Connor and I dive in!
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