Have You Ever Thought About Modeling?

I was working with one of our student traders recently, and we spent a lot of time talking about modeling… trades, of course. Duh.

Modeling option trades is an underused part of any proven trading methodology. I’d go as far as saying that trade modeling should literally be done on every single trade. It’s important stuff!

What Is Option Trade Modeling?

As much as I’m an options Greeks guy and talk about their importance relentlessly, it’s also important to acknowledge “the other” risk management tool: option profit and loss diagrams (or simply, option P&L diagrams) used for trade modeling.

Option P&L diagrams are a clear, visual picture of your risk as the stock price goes up or down. I always encourage new option traders to draw out the at-expiration versions of these P&L diagrams by hand, old-school, with a pen and paper. It’s a great way to get good at understanding absolute options risk—or the absolute most you can make or lose on a trade.

Any options-friendly online broker will also draw these out for you, both in the at-expiration fashion, as well as on today’s days to expiration. The really good platforms will allow you to change inputs, like days to expiration and volatility assumptions, too.

Here’s an example of what this looks like for the March11 435-438 bull call spread in SPY, modeled on the Think or Swim platform.

Trade Modeling 1

The blue line is the at-expiration P&L diagram and the purple line is today.

As you can see, the stock price is the horizontal axis and the profit or loss is the vertical axis. So basically, this tells you for each snapshot in time (expiration or today) what the projected profit or loss will be at any given stock price—a handy little nugget of information.

Zooming in, you can also see in this screenshot, you can change the days to expiration, which will change the purple line to whatever date you have it set.

Trade Modeling 2

That’s a useful tool to see how the profit or loss changes as time passes. The shape of that line becomes an invaluable resource to understanding your position and consequently trading better.

Zooming in to the bottom left, if you click the gear icon, you can then change the volatility assumption. See here…

Trade Modeling 3

That helps because as market fundamentals change and as the underlying stock price moves, implied volatility is likely to change.

Option Trade Modeling

Armed with these tools a trader can really dial in an exact model of an option position, taking into account the three key option pricing factors that affect any trade: stock price, time to expiration and implied volatility. These factors are also measured by the option Greeks. So, in a way, changing the inputs of the purple line is a visual representation of how the Greeks affect the trade.

I personally model my trades before putting them on as well as when monitoring the ones I have on. Modeling the trade by looking at the P&L diagram before making a trade helps me understand whether the trade I’m considering is the best way to trade the opportunity. Checking out the P&L diagram of trades I have on keeps my expectations aligned with reality.

If you’re joining us in Sonoma this June for our Option Trader Training Retreat, you’ll get a drilled-down in-person workshop on modeling trades, going through several examples, different techniques and some ninja tricks I’ve picked up through the years.

And if you’re not yet registered for this summer’s 3-day, in-person Retreat, you can still grab Early Bird registration here.

If you have any questions about the Retreat, give us a call at (800) 944-9262. We’ll be happy to share the details and we hope get you registered.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

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