Trading System Special: Testing Your Trade in Under a Minute

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10 min read

If you think about it, trading can, and arguably should, be like speed dating. When you’re sizing up a particular trade, you’re really asking, “Are you worthy?” In less than a minute, a few numbers can tell you what you need to know. They can help you determine whether to engage, whether to pass, whether to hold, whether to close. Today, trading is about speed. And it’s not like the pros are getting any slower. In fact, you need to get faster. Think about this: in less than a minute, are you able to answer these questions?

  • How much can this trade lose if the stock goes against me?
  • How much can this trade make if the stock goes my way?
  • How does a change in time or volatility impact this trade?

If you’re a retail investor or trader, this one-minute exercise turns arbitrary stop-loss points or profit targets on options trades into quantifiable numbers. So, less guessing. In fact, stop loss and profit targets are easy to determine with stocks whose prices have less to do with volatility and more to do with supply and demand. Some simple subtraction and multiplication can give you the potential profit or loss on different stock prices.

But options prices are determined by the stock price, time to expiration, and volatility, among other things. There are more moving parts, especially with options spreads. Lucky for you, thinkorswim® figures out the math. Specifically, the tools on the Trade page and Analyze page help you answer critical questions.

Tinder for Stocks: Hot or Not?

Consider stock XYZ trading at $240. You’re bullish on it. And you think that a short out-of-the-money put might be a possible strategy cause you’re confident the stock won’t drop and you’re willing to buy the stock at the put’s strike price. So, you discover that the puts on XYZ have 45 days to expiration and find that the 230 puts are trading at $12.17. Armed with this data, you can quickly size up a potential trade to sell these puts short. You can also use the following logic to determine whether you should get out of any trade. (To wit: how to get out of a date gone awry.)

Trade Page: Sizing Up a Single Option

Fire up the thinkorswim Trade page to analyze the theoretical effect when changes in price, time, and volatility occur, before placing single options trades.

Viewing Price Changes

So, how much could the trade lose if XYZ drops in price? Sure, you know the max loss is the strike price minus the price of the put goes to $0, plus transaction costs. But what about $230 or $220? The tool that can answer that is Theo Pricing on the Trade page.

1. On the Trade page, click the Layout drop-down menu at the top of the Option Chain, then click “Theo Price, Mark.” (See Figure 1.)

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FIGURE 1: Accessing Theoretical Price of a single put option in the thinkorswim Option Chain. For illustrative purposes only.

2. A drop-down menu to the right of the Layout menu will appear. Click that to open a set of controls to change the date, stock price, and volatility. (See Figure 2.)

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FIGURE 2: Adjust the stock price to see theoretical price of the put change. In this case, a $20 drop in price would increase the put value from $12.17 to $22.05. For illustrative purposes only.

3. Set the Stock Price Adj field to -20. What that does is use $220 (current stock price $240 minus $20) as the underlying price in the option-pricing model. You’ll see the Theo Price column for the 230 puts jump from 12.17 to 22.05, or a loss of $988 plus transaction costs.

Viewing Time & Vol Changes

Next, by changing the Date and Vol Adj fields, you can see the theoretical option value at some point in the future, and/or as volatility changes. (See Figure 3.) Let’s say the stock price doesn’t change (set Stock Price Adj back to 0), but one month goes by and volatility drops by 6 points. Now the theoretical price is 7.42, which would give the short put $475 theoretical profit (less transaction costs) if the stock price doesn’t change, time passes, and vol drops.

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FIGURE 3: Adjust Date and Vol to see theoretical price change as time passes or volatility changes. For illustrative purposes only.

With these three controls, you can click through various scenarios of stock price, time, and volatility and see what an individual option might be worth. But how about a spread? Or what if you don’t want to figure out the p/l yourself?

Analyze Page: Sizing Up an Option Spread

As we wrote about in “Trade Analysis Focus: the Answer Butler for Your Trades," the Analyze page has a lot of functionality that lets you drill down into all sorts of trade details. But it can also answer the three questions from the in just a few clicks.

Refer to Figures 4 and 5 for the following spread example. Instead of a short 230 put on XYZ as we just did, let’s look at 10 short 220/230 put verticals (buying the 220 put, selling the 230 put).

Viewing Price Changes

To calculate how much the trade might make or lose depending on where the underlying stock goes, locate the Price Slices feature located on the page. (See Figure 4.) A “Price Slice” is just a stock price at which you want to see the theoretical P/L.

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FIGURE 4: Use Price Slices in the Analyze Page to see how prices might change in your option spread when the stock price changes. For illustrative purposes only.

1. On the Add Simulated Trades tab of the Analyze page, enter a simulated put vertical the same way you might enter a real order.

2. You’ll see three slices by default. Enter +15% in the top slice and -15% in the bottom slice. That’ll get you the theoretical P/L of the short-put vertical at the current stockprice (the base), 15% lower, and +15% higher. 15% lower and +15% higher. Or, you could manually change the slices’ default price to see what the P/L would look like if the stock rose or fell by say, $20.

3. You can type in another number for the price slice, or click on Add Slice. That will add a new price slice where you can enter another stock price.

With XYZ down 15% (about $203), the put spread has a $3,536 theoretical loss (plus transaction costs). With XYZ up 15% (about $275), the put spread has a $2,333 theoretical gain (minus transaction costs).

Viewing Time & Vol Changes

Now, let’s see how time and volatility changes affect the P/L. (See Figure 5.)

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FIGURE 5: Then view how prices change in your spread when time passes or volatility changes. For illustrative purposes only.

1. Locate the controls on the right-hand side of the Position and Simulated Trades section of the Analyze page.

2. Click on the little gear icon on the far right to open up the Vol Adj field.

3. The Date and Vol Adj field here work just as they do on the Trade page. Set the date to one month in the future, and Vol Adj down 2 points, and look at the p/l open to see the theoretical profit and loss at the different price slices.

Want to see what happens if volatility increases as the stock price drops? Set the Vol Adj to +10, for example, to simulate implied volatility going up 10 points.

You’ll quickly see that the theoretical loss on the short put vertical could be -$265 plus transaction costs if the stock drops to $170 and volatility increases by 10 points. The p/l numbers are updated immediately with each change in stock price, date, and vol, so you don’t have to wait for the program to chug through the calculations and slow you down. With a little practice, you can do this sort of analysis in less than 60 seconds. Of course you can do more. But here we’re weeding out possible trades so you can find the ones you really want to date. (Dinners and movies and flowers add up.)

This may all seem a little heavy on the numbers, but doing this type of analysis takes just a minute or two once you get the hang of it. And it provides so much information about how to manage a trade beyond simply knowing max profit and loss. Rather than “guesstimating” what an option might be worth in the future on the back of a napkin, you can attach a theoretical value to it.

Now, there’s no excuse for not knowing the impact of stock price, time, and vol on your trading decisions, or for being slow. Or for not knowing that your date likes milk chocolate instead of dark. Or that her mother will never like you anyway cause you’re a trader.

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Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.

Trading options involves unique risks and is not suitable for all investors. Mini-options do not reduce the per share cost or price of options.

Spreads, condors, butterflies, straddles, and other complex, multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades. Be aware that assignment on short option strategies discussed in this article could lead to unwanted long or short positions on the underlying security.

Maximum potential reward for a long put is limited by the amount that the underlying stock can fall. Should the long put position expire worthless, the entire cost of the put position would be lost.

When trading short option strategies, there is a risk in getting assigned early on the options sold, even if they go in the money by $0.01, obligating you to deliver shares you don’t own (in the case of a short call) or purchase shares (in the case of a short put).

The risk of loss on an uncovered short call option position is potentially unlimited since there is no limit to the price increase of the underlying security. Option writing as an investment strategy is absolutely inappropriate for anyone who does not fully understand the nature and extent of the risks involved.

The short naked put and cash-secured put strategies include a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.

Short naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.

A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)

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Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

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