Lost at Sea? The Risk Profile Tool Can Be Your Message in a Bottle

If you were stranded on a deserted island and could choose three things with which to survive, what would you take? 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 be a bit of a stretch. But when it comes to assessing risk on a potential position, the Risk Profile tool would make a valuable addition to any option trader’s survival kit. 

The following, like all of our strategy discussions, is strictly for educational purposes. 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 you visualize the potential profit and loss on an options position. You 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, select the Analyze tab, and then Risk Profile. Next, you’ll want to add a simulated trade, which you can do by selecting Add Simulated Trades, just to the left of the Risk Profile button.

As you type in a ticker, an option 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, select Risk Profile, and there it is in all its visual glory. For example, figure 1 shows the risk profile for a purchase of ten 115-strike call options in a sample stock. 

The Tool Explained, from (A) to (H)

Figure 1 shows the risk profile of a purchase of ten 115-strike calls that were bought for $2.49 (with the options multiplier of 100, that equals $249 per contract, or $2,490, plus transaction costs) and expire on March 16. 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 purple line and an angled blue line. The purple line represents the current date (January 2, 2019). The angled blue line shows the P&L at expiration (March 16, 2019). In the platform, when you hover your cursor anywhere on the graph, the corresponding P&L shows in the bottom left corner (D).

If the underlying stock were to reach $119 on the date in figure 1, the trade is projected to make about $5,000, excluding transaction costs. This estimate changes to $1,510 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 $498. At expiration, a price of $107 in the underlying would result in a loss of the entire premium paid ($490 per contract or $4,900), plus transaction costs.

The short red vertical mark on each line (E) represents the break-even point based on the time to expiration.

That light gray 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 guideline 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 gray 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, select the Lines button (H) and change it to +2 @ Day Step. To the right of that, change Step to 30, for example. Now you have two more curved lines, each 30 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 the passing of time.

Want to see how a trade might fare with changes to implied volatility? Select Lines again and change it to Vol Step, choosing from 1 to 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%.

And that’s the Risk Profile tool—way more powerful than knowing how to crack open a coconut.