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I suppose everybody has heard the above, somewhat modified, quote in a wide variety of contexts. Well, it's no different in options trading! People are trained to look at data in a wide variety of ways. Some feel comfortable looking at a column of numbers, others like charts, and still others like to look at different types of graphs. Our plan is to look at graphical representations of the 6 building blocks of options trading and then later on we'll learn how to combine these graphs into some common and uncommon options positions. These graphs will allow us to glean a lot of information about our positions, just by looking.
So what are these 6 building blocks you may ask? We've seen them all before:
Remember, all our positions are just combinations of these 6 building blocks.
I refer to the following graphs as "expiration graphs." Other writers may refer to them as profit and loss graphs or risk profiles, but they all show the same information. The graphs are constructed by setting up a horizontal and a vertical axis. The horizontal axis show the stock price, while the vertical axis shows a break even at 0, with profits above and losses below.
By looking at the graphs, we can see if our potential gains and losses are limited or unlimited, and also tell if we want the stock to go up or down by expiration. Now you're probably thinking, "if someone needs a graph to tell if he wants the stock to go up or down, he probably shouldn't be trading options (or anything else for that matter.)" Well, right now we're only looking at the most basic and simple positions. Later on we'll look at some positions where it's not so obvious, or where perhaps in one range of stock prices we want the stock to go up and in another range, we want it to go down.
With a little thought, these graphs and their characteristics should become second nature. For example, by looking at the graph of the long Puts, we can see that there is almost (because stock can't go to less than 0) unlimited gain potential on the downside, breakeven with the stock at $47, and losses with the stock greater than $47. The maximum loss is the $3 that was paid for the option and that occurs with the stock at $50 or above at expiration.
Note that these graphs are at expiration only. They are all straight lines and relatively easy to draw. Of course, we can also draw graphs prior to expiration and they will be useful for our risk analysis, but they are more complicated and will be discussed in a future article.
In my opinion, it is very important that you thoroughly understand these graphs, because the next step, which will be adding graphs together to come up with what's called Synthetic Positions, is probably something that you haven't seen before.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!
