Risk Profile Tool: The Option Trader's Travel Companion

Learn how the Risk Profile tool in the thinkorswim platform can help options traders visualize different scenarios and make trading decisions a little simpler.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/map application path with different routes: options risk profile tool
5 min read
Photo by Dan Saelinger

Key Takeaways

  • Understand how to use the Risk Profile tool to identify what could happen if changes in time, volatility, and the underlying happen simultaneously
  • Know how to use the risk graph to determine projected P&L for future dates and when implied volatility changes
  • The Risk Profile tool can help with strike selection, position sizing, and timing entries and exits

Any camper knows you can’t leave home without three tools: a map, a compass, and a Swiss Army knife. These tools help you get where you’re going, give you directions if you get lost, and assist you with basic functions once you’ve made camp. Option traders also need to know where they are, where they want to go, and what could happen along the way when things don’t go as planned.  

When trading options, it’s not just about the price of the underlying. Volatility (vol) and time also impact options prices—and therefore your profit and loss (P&L). What if the underlying moves up $10 but takes two weeks? Or what if the stock doesn’t move but implied volatility (IV) increases 5%? What if IV spikes and the underlying moves? Or doesn’t move? Having a “picture” of a potential trade can help remove some of the ambiguity from trading options.

Part 1 - Defining the High Level

In its simplest form, a risk curve shows how much an options trade can make or lose based on changes in the underlying.

A basic risk graph of a long call, like the one in figure 1, displays hypothetical profits when the underlying price goes up and the losses when it drops. 

options risk curve for long call

FIGURE 1: LONG CALL RISK CURVE. For illustrative purposes only. Past performance does not guarantee future results.

By way of helpful tools, the Risk Profile tool on the thinkorswim® platform shows more than a simple risk graph. It helps you “see” elements that aren’t necessarily apparent in the price of an option. The tool gives you a snapshot of a trade’s risk/reward based on the underlying at the time you do your analysis, at expiration, and any point in between.

Just like a map shows you more than major roads, the Risk Profile tool lets you see plot lines that represent either multiple points in time (including the day of your analysis) or changes in the options IV and underlying. This data can help you get a better understanding of how your trade could perform.

Part 2 - Price, Time, and Volatility

Things can change. What might happen to your trade if changes in time, vol, and underlying price happen simultaneously?

Fire up the thinkorswim platform and select the Analyze tab > Add Simulated Trades > a single option or spread. Then select Risk Profile (see figure 2).

risk profile tool on thinkorswim

FIGURE 2: THE RISK PROFILE TOOL. From the Analyze tab on thinkorswim, add a simulated trade using either a single option or spread, then select the Risk Profile subtab. Here you see an analysis of a long call option for $9.75 with 50 days until expiration. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

Figure 2 shows a long call with 37 days until expiration. The price of the underlying is displayed below the graph, while P&L is to the left. The graph defaults to displaying two lines:

  • Today’s P&L (curved purple line, labeled 1) 
  • P&L at expiration (blue line, labeled 2)

The short vertical red lines (labeled 3) are the break-even points for the trade for that time frame. Hover over the graph to see the projected P&L—it’s based on theoretical options prices for one of the dates in the lower left corner of the graph (4).

The dashed orange vertical lines represent price slices. The middle slice (5) shows the current price of the underlying (in this case $313.20). Select the Price Slices panel to get more control over setting and locking price levels or to add or delete slices.

The shaded area shows the expected range of the underlying based on a one-standard-deviation move and the date in the upper right corner (6). More on this in a bit.

Below the graph are the simulated trades (7) you’re analyzing. You can edit or delete the simulated trades or add others to preview adjustments. And if you want to exclude a trade, just uncheck it.

In figure 2, if the underlying moves to $320.26 from $313.20, the trade could profit $404.19. But if it takes until expiration to get to $320.26, then the trade will have a loss of $448.97 (due to 50 days of time decay). 

You may still want to close the trade with a loss even if the underlying goes up. When might that make sense? To better answer that question, you could add lines to the risk graph that represent the P&L at future dates. In addition to the line for the day of your analysis, add between one and four lines to the graph in any day interval you want.

For example, you could add three lines at 10-day intervals (see figure 3). At the top of the graph, select Lines: > Day Step > +3 @ Day Step and change the interval to 10 using the +/- button. The lines represent the P&L for the day you’re analyzing and 10, 20, and 30 days in the future. Hover over the graph to see the projected P&L for any time frame based on the price of the underlying. In this example, the trade breaks even at the 30-day time frame (white line) with the underlying at $319.39. 

risk profile with day step in thinkorswim

FIGURE 3: RISK PROFILE WITH DAY STEP. The Risk Profile tool on thinkorswim shows the plot line on the day of analysis, along with three additional plot lines at 10-day intervals. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

Remember the expected range in figure 2? Change the date to one in the future you want to analyze. This is just a projection based on current IV, but it can help give you a better handle on how your trade might perform and when you might hit an exit in your trading plan.

To get back to a two-line risk graph like the one in figure 2, select Lines > Expiration > +1 @ Expiration.

Similarly, you can preview how your trade might fare if IV changes. You can add up to four lines that show the effects of IV changes. Enter any interval or change the interval in 5% increments. 

If the underlying drops, the long call will lose from delta. But what if the sell-off comes with an increase in vol? In figure 4, the purple line shows the P&L based on the prevailing IV, but the other three lines show vol increasing in increments of 5%. 

risk profile with increasing volatility in thinkorswim

FIGURE 4: RISK PROFILE WITH INCREASING VOL. See how much you could potentially make or lose if vol increases or decreases. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

If the underlying sells off to $306.71 and vol remains the same, the trade loses $222.71. But if vol goes up by five points (from 27.89% to 32.89%), the trade breaks even because the vol spike offsets the loss to delta. With a 10-point jump in vol (orange line), the trade profits $224.98. Conversely, you could analyze what a drop in vol would do by entering a negative interval number. 

If you want to take this one step further, add in the effects of time decay if there are changes to vol and the price of the underlying. Simply change the date in the Positions and Simulated Trades panel.

 

Changing the Look and Feel

For more control over the look of your graph in the Risk Profile tool:

  1. Select the icon in the upper left next to Drag chart to panDrag prices to change scale.
  2. Select Fixed Y Scale.
  3. Select and drag on the Y scale (profit/loss) or the X scale (underlying price) to tweak the graph.

Part 3 - Strategy Planning

Understanding how a tool works hypothetically is one thing; however, using it in the real world is another. The Risk Profile tool can potentially help make your trading decisions a little simpler when it comes to strike selection, position sizing, and entry/exit timing.

Let’s start with options selection. Plug in your assumptions for the underlying price, time, and vol changes and see how your trade performs. Next, change the strike, expiration, or the entry/exit price. Different trades are going to provide different profit, loss, and break-even points. So, you can use the tool to home in on the trade that might work best for you.

Once you’ve found a trade that could work, you’ll need to figure out how many contracts to trade. Position sizing is a personal choice, and the Risk Profile tool can help you better forecast when profit or loss exits might get hit.

If a projected loss is too big or comes too quickly, consider dialing back the position’s size. If you expect the underlying to move, you may want to give it the time it needs. When you enter your assumptions into the tool, you could get an idea of whether you’ll want to exit a trade based on a profit or loss or make an adjustment.

If a picture is worth a thousand words, the Risk Profile tool could be worth much more. It can potentially help reveal what you can’t see in the numbers. Some traders can look at a list of numbers and visualize the big picture. Others like to have the big picture drawn for them. The Risk Profile isn’t just for the “seeing is believing” crowd.

Kevin Lund is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

Kevin Lund is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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Key Takeaways

  • Understand how to use the Risk Profile tool to identify what could happen if changes in time, volatility, and the underlying happen simultaneously
  • Know how to use the risk graph to determine projected P&L for future dates and when implied volatility changes
  • The Risk Profile tool can help with strike selection, position sizing, and timing entries and exits

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