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Wouldn't it be nice to know the future? It would take the guesswork out of picking your trades. If you were able to see what's ahead, you'd never pick a trade that wouldn't double – or triple – your money every single time.
And you'd always know if a trade is even worth your time, before you waste a single penny.
Now this may seem hard to believe…
… But you can see the future of any trade.
Today I'm going to show you exactly how. It requires just one tool that lets you see your profit potential and risk on a trade, before you make it…
How to Tell Ahead of Time If a Trade Is Worth Your Money
The tool I'm talking about is a risk graph. Risk graphs are a great way for you to see the theoretical value (or profit potential) an option has at different prices and different time intervals up until expiration, based on the underlying stock price.
Let's get started by looking at the risk graph on a long call:
First, it's important to note that this chart is a little different than most risk graphs. Most risk graphs are shown in what's called a "modern view," which means the "Profit ($)" on the vertical axis and the "Stock Price" on the horizontal axis.
Instead of using the modern view, my graph above shows the "Profit ($)" lying on the horizontal axis, and the "Stock Price" on the vertical axis. I can flip flop the axes since this graph is from my own tools. This is a much better view in my opinion, as it allows me to look at the price of an option the same way I would when looking at a stock chart.
Whichever way the graph looks, the information should be the same…
Let's take a look at the five components of a risk graph. To make it easy, I labeled each part:
- Stock Price. This is the price of the underlying stock.
- Profit ($) per one contract. This is notthe option's premium (the price you paid for the option), but its value. If the graph shows 200, then it means the option's value, not its premium, has increased $200. For example, say the cost/premium to open your position was $3.00 (or $300, since one contract equals 100 shares), and it has now grown to $5.00 (or $500). This means that the profit – or value – of the position is $200 ($500-$300 = $200).
- Each of the different colored lines that starts to the left of the "0" vertical axis represents the loss (or depreciation) of the option's premium up until its expiration. The black line represents the option's expiration. The maximum loss (100% of the option premium) is realized when the stock trades at that price or lower at expiration.
- Each colored line to the right of the "0" along the "Profit ($)" axis represents the profit potential (or value of the option) at the specific time interval and price (these are also colored lines). Long calls theoretically have unlimited upside value potential, as there's no limit to how high the stock can climb. Just keep in mind that options do eventually expire, so this unlimited profit potential only lasts until market close on the day of expiration.
- The red line represents the number of days the option has until expiration.
- The blue and green lines reflect that one-quarter of the time to the option's expiration has elapsed. Remember, the black line represents its value on expiration day.
- The dark blue horizontal line is the breakeven line. It shows you the share price and time intervals the stock needs to be at to break even. When you break even, it means that there's no gain or loss on the trade.
- The light blue line is where the stock needs to be at the breakeven point at expiration.
Remember, the risk graph is a reflection of the risk and profit potential of the option strategy you choose to use.
Some strategies allow what's called an unlimited reward potential, which is when the option can increase as far as the stock can go. Other strategies have limited risk – and limited reward – such as spread trades.
I'll get into that in the near future, so stay tuned. For now, we're going to see exactly how risk graphs can reveal the destiny of a trade.
Using the Risk Graph to "See the Future" of Two Simple Options Plays
Now that we've broken down each piece of the risk graph, let's look at how it can tell you the future of your trades – and whether they can unleash an unlimited stream of cash for you.
- Long Calls
When you buy long calls, your maximum risk is simply the price you paid for the option times the number of contracts you bought.
Now you may be used to hearing the term "limited risk" when you think of long calls, but just keep in mind that your maximum risk is the total cost of the trade. You can still lose 100% of the money you spent on the trade. The reason it's deemed limited is that it costs you less money to buy an option on a stock than to buy the stock itself.
Take the Microsoft Corp. (Nasdaq: MSFT) June 17, 2016 $47 Calls, for example:
If the option's premium (how much it cost) is $3.30, then your maximum risk potential is $330, because one contract is equal to 100 shares. In this case, the maximum risk is realized when the stock trades at $47 or below – as the black line on the graph shows below.
Here's how the risk is graphed out:
Using the risk graph, you'll want to see if the stock shows any of those colored lines at that "Profit (S)" axis – even if you have to look at the black line (representing the option's expiration). And if any of the lines hit the profit amount that you need for the option to double in value, then you know ahead of time if the trade is really worth your time pursuing – before you spend your first dime.
And if the graph doesn't show a potential for the option to double in value…
… then assess the return you can get (in either dollars or as a percentage) if the stock reaches the price you think it will. It will be up to you to determine if the trade still seems worth your time and money based on the return you'd get.
And in the case of the Microsoft (Nasdaq: MSFT) June 17, 2016 $47 Calls, whether or not that $3.30 premium is really worth it depends on what the price the stock needs to hit in order for that profit bar to show a 50%, 60%, 70% – or better – return.
In the graph above, you can determine that by going from any of the colored lines over to the stock price. Now my tools highlight this, but what you're looking for is the option's profit at that specific share price (shown on vertical axis) as of that specific time (shown by different colored lines).
In the graph above, you can see that the stock needs to climb to $53.50 in order for you to reach a profit of $330, which is what you paid for the trade. Of course, the higher the stock climbs, the more profits you lock in… and since you bought a call option, you're looking at potentially unlimited profits if the share price keeps moving up.
And if you don't believe the stock can move your trade into position to double your money between now and the expiration date, then you may want to strongly consider finding another trade idea OR you can use the risk graph to ascertain what your profit value will be at a different time and price.
Let's look at one more example…
- Long Puts
When you buy puts, your maximum risk is the same as a long call – the price you paid for the option times the number of contracts you bought. And just like buying a call option, it's cheaper to buy a put on a stock instead of buying the stock outright.
Although I'd like to say that you have unlimited profit potential in a long put scenario, that's technically not true…
Unlike calls, where there's no limit to how high the stock can climb, there is a limit to how low the stock can drop… ZERO. So keep in mind that while your profit potential for long puts is substantial, it's not unlimited.
Now let's use the Microsoft Corp. (Nasdaq: MSFT) June 17, 2016 $150 Puts for our next example:
The maximum risk shown above is for one contract. The option's premium is $4.80 (or $480). The maximum risk is realized when the stock trades at $150 or higher.
No matter how high MSFT goes above $150, the maximum amount you can lose is what you put in – $480.
Looking at the risk graph lines in the MSFT option scenario, can this option double in value any time between now and expiration?
Now if the stock somehow dropped to $141 right now (the red line), then there's a small chance of the trade doubling in value… But as I see it, none of the lines intersect at $480 on "Profit ($)" axis.
But before you move on to an entirely new stock and option… how about taking another look at these lines and seeing what happens if the stock moves to $141 – even if you have to wait until expiration for it to get there?
You can look at the stock price at any time interval, but why not look at the worst-case scenario, which to me is when the option expires. The reason this is the worst case is that you've run out of time for this trade to work.
Let's say that at expiration, MSFT is trading at $141. The MSFT June 17 2016 $150 Put should then show a profit value of about $410 along the "Profit ($) axis. The question now is whether or not you believe that MSFT will actually make it down to $141.
If you think it will, then your next step is calculating your theoretical return on investment – or ROI. A profit of $410 on a trade that cost $480 is 85%. Now this isn't a double – but 85% isn't bad, either.
And if you don't think it will, then it might be time to consider a new opportunity…
The point of all this is you can see the future of a trade using a risk graph. You can assess the theoretical value of an option when the stock hits a certain price at a certain time prior to – or at – expiration. You can also know ahead of time what your rate of return and profit potential could be… allowing you to decide whether or not you want to spend your time… and your money.
And the best part is…
A risk graph will help you determine the worst that can happen to your trade so that you can rest better at night.
Too many options traders place trades and fear the unknown. But no longer do you have to worry about what could happen to your trade – and when…
Risk graphs lay it out for you ahead of time.
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About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.