This will be the last in the series (for now) on using the Options P/L Graph.
As I’ve explained previously in Part 1, Part 2 and Part 3 of this series, the P/L graph is a crucial tool in getting the most out of your option trading. Some form of it is a part of every good option trading software platform. It is well worth your while to master it.
In the previous installments, we’ve concentrated on how this tool relates profit on an option trade to the stock’s price. Some option trades are designed to pay if the stock goes up; others pay us if the stock goes down. The P/L graph can tell us how much we would make or lose based on the change in the stock price.
To wrap up this series, we’ll look at how the tool helps us measure the effect of something other than the change in the stock price – namely, the passage of time.
You are probably aware that every put or call option loses a fraction of its value with every day that passes. Option buyers want the stock to make its move as soon as possible, so that they can sell the option for the best profit. If it takes too long for the stock to reach our price target, some or all of the profit can be sapped out of the trade. This is an important consideration as we plan our trades.
The example below is for a bearish trade on SPY, based on the expectation that SPY was likely to drop from its then-current price of $283.90 to $278.00. It involved buying a December Put option at the 285 strike price. Put option prices in general go up in value as the price of the underlying asset goes down. This particular Put’s cost at the time of the example was $8.61 per share, as shown under Price at the bottom center of the screen shot.
Each Put option covers 100 shares of the underlying asset, so the cost per put option would be $8.61 X 100 = $861.00.
The various lines on the graph show what the profit on the Put position would be if SPY reached that $278 target at different dates in the future.
SPY’s potential prices are shown along the horizontal axis of the graph, with prices increasing from left to right (or decreasing from right to left, however you want to think of it). The vertical axis measures the profit that would be made on the trade with SPY at any designated price.
The vertical line at the $278 price cuts through four different-colored lines. Each line represents the profit picture as of a different date: the current date with 127 days to expiration (gold line), the expiration date with zero days to expiration (red line) and two intermediate dates with about 1/3 and 2/3 of the time to expiration elapsed (blue and green lines), respectively.
The table below the graph lists some information about the position assuming a $278 price for SPY at each one of those dates. Included on each line is a number for Value, which is the estimated value of the option, and Theo P/L, meaning theoretical profit or loss.
Theo P/L is the Value amount minus the $861 cost. Note how different the results of the trade will be, depending on how long it takes SPY to reach our target. The best case is that it happens immediately. The first line in the table tells that in that case, the Value of the option would be $1,171. Subtracting our $861 cost would give a profit of $310.
If it took about a third of the 127-day lifespan of the option (44 days) for SPY to reach its target, we would then be at 83 days to go. The second row of the table tells us that our profit at that time would be only $186 instead of $310.
If it took still longer, say until there were only 43 days to go, the third row of the table says that our profit would have dwindled to just $40.
And if it took all the way until the option expired after 127 days, even though we did reach our target the position would actually show a loss of -$160, as shown in the last line in the table.
This drop in option value over time is called time decay. It’s one of the key factors that we must take into account on every option trade. Option buyers can make large profits if they are right about the direction they believe the underlying will take – if they are right in time.
Using the option P/L graph is the best way to know what we are getting into on every option trade. Making it one of your go-to tools gives you the best way to put the probabilities in your favor – and that’s what all trading is about.
Read the original article here - Using the Options P/L Graph Part 4