Options trading can be stressful. Determining how you'll manage a new trade can produce angst. Trying to determine how that trade will be impacted by certain market forces can be daunting. I always advise backtesting to gain knowledge about how the trade will react under certain conditions.
There's another way, and it can be less daunting and more playful. Let's use a simple trade, an AAPL put debit spread that was utilized in last week's Options 101. This 14-contract AAPL DEC 118 put/113 put debit spread theoretically opened on November 28 had been set up to profit from a possible drop in AAPL to about 115 before the stock bounced again. You can review the premise of the trade here. I had chosen the hypothetical trade to illustrate how one might go about evaluating a new trade possibility.
The first part of that scenario--the drop to about 115--was soon realized. If a trader is evaluating such a trade for viability or even if in a similar trade, what should a trader do next if presented with a profit so quickly? Remember that my articles are roughed out well ahead of publications and charts do not reflect current price levels. The dates the graphs and charts were snapped are included in their titles.
AAPL Daily Chart as of the Close on Tuesday, DEC 2, Chart by Think-or-Swim:
This AAPL daily chart from December 2 shows that the first part of the scenario, that possible drop to about 115, had been realized, and more! Much profit was available to be harvested. What would happen next? What would happen if AAPL climbed and retested its previous recent high within a few days? If it consolidated for a week? If it dropped further?
I'll be using OptionNET Explorer, a subscription-based trade graphing resource, to do most of the testing a trader might use to evaluate the prospects and/or adjustments for this hypothetical trade. Most people have the ability to perform most of these tests on a free simulated trade platform via their trading platform or the CBOE's free simulator. The choices one can make may be more limited and the graphing more rudimentary, but most of us have this capability experiment at least a little with how our trades might perform under certain conditions.
Trade's PnL as of the Close, December 2, Five Days into the Trade:
Hypothetical profit of $1,855 had been accrued after two-way commissions of $1.25/contract had been subtracted.
The original scenario had been that AAPL might drop to about 115 before attempting to rise again to challenge its recent swing high. What would happen if AAPL next rose to about 119.68 in about a week? We know from our current vantage point that AAPL did not rise back to 119.68, but a trader evaluating the trade on December 2 couldn't see into the future. Neither could I when I first roughed out this article on December 2, so you're watching the kinds of tests a trader might be undertaking to test future outcomes. Those tests, in this case, were of possible outcomes a week out from December 2.
AAPL Profit-and-Loss, Time Rolled Forward a Week (See "T+7" beside the "Tue 09 Dec 2014" designation near the top right of the graph.)
The arrow points to the profit-and-loss line with these conditions imposed, with the price at about 119.75 by December 9. The ONE platform provides a second tab that slides along, providing the exact loss at that moment (-$541, including two-way commissions), but the tab disappears when I try to take a snapshot of it. Hence, the drawn-on arrow. Delta is an alarming -382 at that point, which means that the trade theoretically would lose another $382 for each point further that AAPL climbed. Those who are not interested in or knowledgeable about the Greeks of options position pricing can just take a look at the slope of the profit-and-loss line. It's clear that it's slanting down rather steeply toward the maximum loss.
Sometimes when prices climb, implied volatilities drop. You can see from the "Volatility Adjust" button's setting on "0" that I didn't lower implied volatilities. I don't like to do so if I anticipate that a hypothetical rally could be quick, with shorts scrambling to buy to cover their positions. Sometimes implied volatilities don't settle down under those kinds of rally conditions. However, we're just being playful and experimenting with what was always a theoretical trade, so let's take a look at what would happen if implied volatilities dropped a couple of percentage points.
Time Rolled Forward and Implied Volatilities Lowered:
The difference isn't easy to see on this graph, but ONE's pull-down tab tells me that the loss at $119.68 would now theoretically be $667. With this particular trade, you may remember from previous articles, the profit-and-loss line is driven lower when implied volatilities drop if the price is above the expiration breakeven. A drop in implied volatilities when price is above the expiration breakeven would allow the profit-and-loss line to sag toward the expiration graph's maximum loss. In some other trades--such as when price is moving toward the sold call in an iron condor from under the condor's tent shape--the loss would be ameliorated rather than worsened if implied volatilities dropped.
Another possible scenario for evaluation on December 2 was this one: what if AAPL's price consolidated for a week and December 9 had found AAPL's price the same theoretical $114.63 as it ended the day on December 2? Under that kind of condition, the implied volatilities probably would have dropped. The price would still be below the expiration breakeven rather than above it, as it was in the rally situation. Would dropping the implied volatilities also worsen the profit-and-loss figure in this case?
We can find our answer by looking again at the last graph. The hypothetical profit if AAPL had stayed at $114.63 for a week with implied volatilities dropping would be $1,995, up from the $1,855 profit on December 2. In this case, PnL has been helped by a lowering of IV's as well as by the passage of time. Because in this scenario the price has stayed to the left of the expiration breakeven, the lowering of implied volatilities has allowed the profit and loss line to rise toward the expiration graph's maximum target.
In fact, AAPL was very near $114.63 as the day drew to a close on December 9. Composite IV's had dropped, too, allowing a test of the rolling-forward hypothesis.
PnL Chart Near the Close on Dec 9, with AAPL at $114.62, with Composite IV's lower by 1.53 Percentage Points:
The hypothetical profit was $2,156, a bit more than the profit that had been predicted on December 2, when various hypotheses were being tested.
It wouldn't have been hard to imagine on December 2 what would happen if AAPL dropped further in price. The profit-and-loss line tells us that profits would grow. But what if implied volatilities had risen, as often happens when prices drop? We know what happened now but back on December 2, we couldn't have been sure what would happen next. We could, however, have imagined that a rise in implied volatilities might hold back the profit-and-loss line from rising quite so quickly toward the expiration graph's maximum gain. The trader who is playing around with these inputs could test that theory, and so might you. Or perhaps I could just mention that as of 11:46 am CT, Friday, December 12, with AAPL having dropped to 110.60 and implied volatilities haven risen considerably, the hypothetical profit in the trade was still $3,948. Those rising implied volatilities had dampened the rise toward the maximum profit near $5,000, but I don't imagine that any trader who had elected to stay in the trade would have been complaining.
For whatever it's worth, I wouldn't have stayed in the trade, at least not with the full position. When AAPL dropped quickly toward $115 and profit rose to 93 percent of the maximum margin in the trade, I likely would have exited the position or at least most of the contracts. Remember that our original hypothetical premise was that AAPL might try to climb back toward its previous swing high after testing 115. I would have tried hard not to sing the old woulda-coulda-shoulda song, just as I'm trying hard not to kick myself for not putting on the trade live rather than just using it to illustrate a couple of articles.