Profit and Loss

What is Profit Loss?

Profit Loss is a calculator that accounts for options pricing models and returns the option's potential gain or loss based on market movement and days until the options expires. Using a calculation, Profit Loss is an educational tool that can help you understand the potential hypothetical reward and risk on the position.

4 Ways to Use Profit Loss

  • Get a visual representation of your computed strategy's profit / loss before or during a trade.
  • View potential changes to your profitability or goals based on adjustments to market forces (volatility, days until expiration, and underlying price).
  • Understand different trading strategies by exploring multiple option contracts.
    • Add up to four options legs to analyze spreads.

Volatility Types

  • Implied Volatility measures whether option premiums are relatively expensive or inexpensive. The implied volatility calculation is based on the currently traded option premiums. A mathematical formula--using stock price, strike price, time to maturity, interest rate and historical volatility--is used to arrive at the implied volatility number.
  • Historical Volatility is the actual value based on market data. For example, a 30-day historical volatility is a 30-day average of actual market volatility.

Understanding Profit Loss

Profit Loss is helpful in measuring the potential profit and loss of a theoretical options position. The Profit Loss tool can help you analyze new strategies from buying calls and puts or advanced spread based options trades. Profit Loss estimates are based on the Black-Scholes method, which uses for the current stock price, the intrinsic value, time to expiration, volatility, and interest rates to establish a premium price. Because these values constantly change, the values of an option price constantly change. The ever-changing state, can present a challenge to someone trying to forecast potential reward-risk on his or her trades.

After you choose the option contract or option spread and the Profit Loss tool populates, a graph displays. The Profit Loss tool uses the current real-time option price to calculate the risk graph, but you may choose to enter your own price to either simulate a specific price or to model an existing trade. The X axis on the Profit Loss graph represents the underlying stock price while the Y axis represents the Profit or Loss on the position. When you move your cursor over the graph, the crosshairs display and move both X axis and Y axis to pinpoint specific prices along the risk curve. To forecast a profit or loss, drag the crosshairs along the X axis until you reach the desired underlying stock price, then move the mouse up or down to find either the black or blue line to establish what the profit or loss would be at that price. In addition, when you click the graph, you will see a snapshot of the option Greeks at that price next to the Scenario at the bottom of the window. On the right of the risk graph is a summary showing key points for the hypothetical trade such as breakeven, maximum profits and loss, and a payoff table for specific stock prices.

Modelling with Profit Loss

The Profit Loss tool lets you model either specific, manually-entered options positions or pre-selected options spreads chosen from the tool directly. After you choose the options contract, you will see a graph that forecasts a projected profit and loss based on the current underlying market price. By default, the Profit Loss graph displays two pricing forecasts. The first forecast is represented by a black line and shows the price of the option at expiration. The second forecast is depicted by a blue line, which represents the real time option price based on the current days to expiration. Note the differences between these two forecasts and how they can be interpreted. For example, if you are looking at a December Expiration and it is currently October, the black line represents the value of your option at expiration in December, not the value if the underlying market were to suddenly increase or decrease in price. For a current forecast, you would look to the blue line, which is based on the current days to expiration.

At the bottom of the Profit Loss window, you can adjust the days to expiration to help forecast price on certain days. For example, if your analysis shows a $10.00 move in an equity in two weeks, you can model this by adjusting the days to expiration forward by ten days. Remember, options lose value every day based on time decay (Theta) and this loss needs to be modeled to accurately to assess the performance of the position. You can also adjust the volatility using either a pre-selected amount based on the implied or historical volatility computed by ScottradeELITE. For example, you can take the anticipated time for your trade (what you expect to be in the trade for 60 days) and use that amount (60 Day IV or HV) to model the trade. Additionally, you can adjust the interest rate. In addition to the to the two default forecasts, you can use the Profit Loss tool to add more market scenarios to your strategy.