After recently reading an OIC pdf titled "Understanding Profit and Loss Graphs," I realized that I've been putting the cart before the horse in some of the my articles. I've been showing PnL charts from Options Oracle or OptionsXpress or the Analyze page from think-or-swim, when some of our readers might be unfamiliar with how they work. Experienced traders might not be familiar with the way different platforms display this information. Last week, I went back to basics, setting up a butterfly trade on such a chart and talking about what we could discern from studying the chart. We discussed the expiration line, the expiration breakevens, the percentage potential for profit and the maximum profit and loss. However, the article was running too long to continue the discussion to the "today" line or the way we might use such charts to test an adjustment we're considering.

For review you can find last week's article here. I'll also show the initial chart we were studying, for easier reference. To be clear, I picked IBM for this example because it was close in price to one of its option strikes. I don't tend to trade butterflies on IBM and was not recommending this trade but only using it as a graphing example. Someone who regularly traded butterflies on IBM would know how far it's best to place the wings away from the central body, for example, and how far ahead of expiration it's best to place the trade. As I mentioned last week, I thought the percentage of the time that IBM would be within the expiration breakevens at expiration, displayed at the top of the graph below, was a little low for the way I like to set up butterflies, anyway.

Tent Shape for a Butterfly:

Depending on the source of the profit-loss or analysis chart, a "today" or "t+0" line may be shown. That's the white line in this example from think-or-swim. That line isn't entirely trustworthy in all examples, but it's a helpful guideline for testing how the trade will perform under certain conditions on any given date. Most charts allow for an adjustment to T+1 or T+2 or another date "x" number of days ahead of the current one, or allow traders to select and view the theoretical performance on a certain calendar date. This line may be most helpful when it's used in an end-of-day check of the trade, determining whether an adjustment needs to be made before the end of the trading day in preparation for the next morning's open. Another particularly important use comes to mind when the trade is first set up. I don't like to take my trades into expiration week if I can help it, so it's not the performance at expiration that concerns me. What instead concerns me is how soon is the trade going to need an adjustment and what will my unrealized loss be at that point? Say that I have a profit target of 20 percent on a butterfly and also have a maximum loss of 20 percent I will accept before taking myself out of a trade. I might look at a price chart and determine where I think the strongest support and resistance might be. I might also choose where I think the underlying is going and where I'm afraid it might be going, maybe over the course of the next few days after the trade is established. If it goes where I'm afraid it might be going in the first three days after the trade is established, for example, will I already have hit my maximum planned unrealized loss, before I even get to the first adjustment point I'd planned? If so, that's either not the butterfly setup I want or else I need to change the place at which I plan to adjust. However, I still use this most often for my end-of-day planning ahead of the next day's open.

For example, in these days when we often see big gaps in the mornings, the trader might be understandably concerned with what might happen if markets were to move big one morning, with IBM gapping one direction or the other. Although IBM doesn't tend to be the "gappiest" of stocks, it did gap from its closing price of 187.25 on 11/08/11 to its opening price of 184.20 on 11/09/11, for example. This white line seems to indicate that a gap of the same magnitude the day after this position was established wouldn't be a big deal. Is that true? Let's roll the graph forward a day (not shown) and increase the implied volatilities a bit to see if the white line changes. Without those changes, this graph seems to show that the position would be profitable by about $3.87 minus commissions if IBM were to drop to $180.20. Rolling the graph forward a day and increasing the implied volatilities a bit lowered the price that could be expected the next day at 181.20 to a loss of -$14.19 plus commissions. This difference isn't major in this case, but manipulating the parameters in this way and watching how such manipulations impact that "today" or "t+0" line helps traders make plans for adjusting their trades.

Options traders should be aware these charting programs are not perfect. Far-out-of-the-money options, particularly far OTM calls used to hedge positions, may not perform as well as expected as a sold strike is approached or expiration nears. No matter what option-pricing formula that a PnL chart uses to compute these costs, they may overestimate the hedging ability of an OTM call near expiration. Since 1987, implied volatilities in puts have generally remained stronger than those in calls so that the puts tend to hold their values a bit more, although these rabid rallies we've been having may change that skew history.

Still, as the OIC's simple pdf explanation points out, combinations of options positions are almost endless and can reflect nearly any kind of viewpoint on what will happen in the markets. Charting a position can help you craft a position beyond the standard ones that better reflects your risk tolerance or outlook, as long as the trader has enough experience to understand the pros and cons of such a beyond-the-standard adjustment. Being able to test the adjustment helps reveal those pros and cons, although nothing is a substitute for live trading.

Suppose, for example, it was my viewpoint that on the day the previous butterfly was constructed that IBM was likely bottoming out? (Note: I didn't even look at a chart, as this discussion is about PnL charts, not IBM, so I didn’t have a view at the time this article was roughed out a couple of weeks ago.) In this case, I might want to construct a different butterfly than the one shown previously. I might have wanted an unbalanced butterfly-ish trade that might work well if IBM stayed around its then current level or went higher. However, maybe I also wanted to cap my loss if I was wrong and IBM was about to head lower instead. I've unchecked the box on the original butterfly and added a custom trade with a butterfly-like tent shape near the sold strike, a trade constructed of 3 sold DEC 11 185 puts, one long DEC 11 190 put and two long DEC 11 180 puts.

IBM Unbalanced Butterfly:

If I'm wrong about my theory about IBM, this chart shows me that the most I will lose will be $388.00 plus commissions. If IBM churns around all the way through to December's expiration near the current level or slightly above, that trade could make a lot more than $388. If it shoots higher and keeps going, the trade will make at least $112.00 minus commissions. Is that enough to convince me to tackle this trade? That would depend on my outlook, but it's clear that studying a PnL chart would help me refine my knowledge of what the risks and benefits of the trade would be. This chart shows me that such a trade would be a directional one and one in which the loss I could sustain would be far higher than the profit I would be likely to make unless IBM just stayed at the same level for a long period of time. In my eyes, that trade would be not only directional but also speculative, so if I felt inclined to try a trade like that, it would be only in the "lottery money" portion of my trading capital. This TOS chart helps me test the way I would adjust the typical butterfly setup at inception to reflect a specific market view.

Think-or-swim's analytics page is among the best of all the brokerages', but even the clunkier OptionsXpress and BrokersXpress pages can show you some of these things. I'm not hyping TOS with this article. In fact, it's been going through some growing pains lately that should be considered by anyone examining the different platforms.

OptionsXpress' PnL for Same Unbalanced Butterfly as Seen on TOS' Page:

I imagine most brokerages that cater to options traders provide some sort of analysis page. If not, you can find them elsewhere. I've shown freeware Options Oracle on these pages previously, although I couldn't access their charts as this article was being prepared. Other proprietary charting systems exist.

It's not necessary to use such charts to survive as an options trader in a live trade. I'm not the most proficient person you'll find with such charts. I use them how I want to use them and don't always bother with all the bells and whistles. In addition, some of my best years with options trading were spent without such charts. However, I can't imagine not using them now because I can view a picture of how the trade will react to certain adjustments rather than just viewing a series of numbers relating to the new Greeks of the trade. This discussion hasn't even touched on the benefits of such charts in back testing, which some such charting systems allow and some don't. I can certainly say I've gained in my knowledge of the flexibility of options since I began using profit-and-loss or analysis charts. If you're new to such charts, start with the simplistic OIC pdf linked above and go from there.