Risk Starts Before The Trade, Not After

Will McBride and Dmitry Pargamanik cofounders of Market Chameleon join IBKR’s Jeff Praissman to discuss the value risk management tools in option trading. This podcast is a follow up to their insightful webinar, “How To Use An Options Profit Calculator”.

https://ibkrcampus.com/webinars/how-to-use-an-options-profit-calculator

Summary – IBKR Podcasts Ep. 143

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi everyone, welcome to IBKR podcasts. I’m your host, Jeff Praissman. It’s my pleasure to welcome back the co-founders of Market Chameleon, Will McBride and Dmitry Pargamanik.

Will McBride

Hey Jeff, how are you?

Dmitry Pargamanik

Thanks for having us back, Jeff.

Jeff Praissman

Ah, my pleasure. It’s great to see you guys. And I want to thank you for coming by the IBKR podcast studio after the webinar we just did on using option profit calculators. And for our listeners, if you missed the webinar, there’ll be links in the viewing notes.

So Will and Dmitri, we’ve spoken actually in our most recent podcast, Episode 137, “Don’t Trade Blind, Use Data” about using data for option analysis. Today, though, we’re going to talk about using an option profit calculator. In general, why is option analysis important?

https://ibkrcampus.com/podcasts/ibkr-podcasts/dont-trade-blind-use-data/

Dmitry Pargamanik

That’s a good question. My brother actually asked me, why do I need an options profit calculator to run an analysis? To give an example, if I buy a house, for example, a piece of real estate, if it goes up 10% I make 10%. If it goes down 10%, I lose 10%. Yes, that’s a simple way of looking at it, but an options profit calculator tries to help answer questions that are more complicated than that. So as an example, what if you bought a piece of real estate and you didn’t pay cash for it, but you took out a mortgage of 20%. And then you expected to rent it out and make $300.00 in rent by the end of the year, after you paid off your mortgage. And maybe you built up some equity over a year’s time and then maybe you wanted to take a tax write off benefit for depreciation. So as you could see, as you’re giving more inputs and you wanted to see in a year, where’s my break even? Or where are my profits and losses?

Those are the things that the options profit calculator in the options world will help answer. Those more complex, complicated questions when you add all those types of variables into the calculator.

Jeff Praissman

It sounds like you’re adding in market assumptions to make the calculator work. Which ones are most useful? I’m sure there’s a lot of useful assumptions, but some might have higher priority over others.

Dmitry Pargamanik

Yeah. And there are different calculators that will perform different tasks. The most basic options profit calculator is you’d have to enter the option legs in your strategy. So if you have more than one leg, like the call spread or put spread for three legs or four legs, you would need to enter those in. If there’s a stock component, you would want to add that in. Of course you would need the prices for each one of those legs. And usually the most simplest calculator, the first question you would have is, well, if I did this strategy, and I held it to expiration, what would the payoff be if I did it at these prices if the stock price in the future that expiration was here or here or here?

And that’s what an option profit calculator (a simple one) will help answer. A payout. A profit or loss at expiration. So at the very least, you would need those basic inputs to plug into an options profit calculator.

Jeff Praissman

And then I would assume too, like there may be the more complicated ones might interpret some economic inputs such as like interest rates or dividends or something like that?

Dmitry Pargamanik

Yep. Exactly. So that would be one way to use the options profit calculator.

Now of course you could then expand it and put in other assumptions if you wanted to see potential profits and losses even before expirations, and then in those cases you would need to put in new variables or new inputs that are important for option pricing, such as interest rates, implied volatility assumptions, dividend assumptions and so forth.

Jeff Praissman

So, obviously besides for seeing the options profit, what are some more specific reasons an investor would use an option calculator?

Dmitry Pargamanik

Yeah. So the very first reason you’d want to run the options profit calculator is to really visualize your risks and rewards in your particular strategy. So most option profit calculators will draw you a diagram, so it’s really hard to change a price from one to the other and keep track of that.

So a payout diagram is much nicer. The options profit calculator (a powerful one) will show you the profits and losses at expiration along different price ranges. So you could kind of see, as the price is going down, what does your payout look like? And as the price is going up, what does your payout look like? What if the stock chip sits at the same spot? So that diagram, visually, will show you how this particular strategy performs at expiration along a wide range of prices. And then you could see your risks and rewards. Where do you stand to make the most? Where does it look like you stand to lose the most? Are you capped on your risk? Are you capped on your rewards?

So that’s an important piece of the options profit calculator. The function of an options profit calculator. Another important thing is that when you visualize the payout diagram, you will be able to really determine what the option profit calculator is showing you. Does that align with your particular outlook on the future of the stock? Is this way you feel, your analysis and your forward forward-looking unique outlook, does it line up with the strategy? So that’s important as well, because if you’re very bullish, and you look at a particular strategy and then you’re saying well, this does not really line up with my outlook, well, now you will be able to change that strategy or tweak it until it does.

Another aspect of the option profit calculators or just option pricing calculators is that you could also see the sensitivity of your particular strategy to different risks exposures.

So one for example, you have your Greeks. Your Delta, Gamma, Vega, Theta. Rho Greeks. And by plugging in all these assumptions, an options pricing model calculator, not exactly a profit calculator, but what it will do is allow you to assess what your risk exposure is. What is your risk exposure to a directional move in the stop, up or down? What is your exposure to option decay? If nothing happens, how much is this position expected to lose time-value from now till tomorrow?

You could look at the sensitivity of your particular strategy to interest rates. And implied volatility. What if the implied volatility’s moved up or what if the implied volatility’s moved down? How sensitive is this particular strategy to those inputs?

And that’s really important because not only do you see and evaluate what your risk is, but those are controls in place that allow you to manage and mitigate your risks as well.

Jeff Praissman

So I have to ask you something that I’m sure some of our listeners might be thinking.

So if I have an option profit calculator and it’s telling me, I’m putting these inputs and it’s telling me my strategy is profitable, does that mean it’s like a surefire lock win here? Or  is there room for error?

Like I’m sure our listeners are thinking, oh well, I can get an option profit calculator and know if I’m going to win or lose on this trade.

Dmitry Pargamanik

Yeah. So the option profit calculator, it can’t determine if the strategy will be a winner or loser. It’s more of a “what if” scenario. You’re looking at different theoretical scenarios and the option profit calculator tries to show you how this strategy would perform under this scenario or that scenario. So it’s more of a helpful tool to help you assess your risks and potential rewards versus potential risks. But it can’t really tell you in 10 days or 15 days that this will definitely be profitable or unprofitable because it doesn’t know that. It’s only helpful for running what if scenarios.

Jeff Praissman

I see. So unfortunately no easy money, right?

If you could, could you guys dive into some of the areas where a calculator could fall short? I guess maybe some potentially unexpected inputs that it maybe is not necessarily built well for.

Dmitry Pargamanik

Yeah. A lot of it has to do with your inputs and your assumptions that you put in there and it’s just going to give you an output, of course. So a lot of the limitations are that some of the assumptions are uncertain. If you’re going to put in implied volatility assumptions, you can put in an interest rate assumption, and there are even dividend assumptions. But it could be wrong. And the option profit calculator doesn’t know, it’s just going to calculate whatever assumption you put in there.

So always when when you’re dealing with those types of uncertainties, that’s a shortfall. Because it’ll only calculate something that you input, right? The other things to watch out for and we’ve had this come up with some users is that they mentioned, well if I do a call spread, and the option profit calculator could draw you a profit and loss diagram at different prices at expiration. But you still have risks in there, such as assignment risk or what we call early exercise risk.

Your strategy could be broken up and the option profit calculator wouldn’t know that, right? So it just runs on these assumptions that whatever is inputted, that’s the way things will behave.

So if you, let’s say, have a call spread, if the stock closes in between your strikes or what will happen is if you don’t close out of that call spread at expiration, one of the legs will expire worthless and go away. The other leg will be in the money and you’ll get assigned and that will convert to stock, right? So if you don’t do anything, all of a sudden the following day after expiration, you’re going to come in with a stock position, long or short, depending on which leg you get assigned.

So the option profit calculator wouldn’t know that. It’s just assuming that this is what you’re putting in and it would assume that you just close out of it at expiration. Or nothing gets converted. So there are things to consider when you’re using the option profit calculator. There are limitations for sure.

Jeff Praissman

You touched on it- the early assignments where that risk if I’m short an option or say I’m doing a calendar spread or a vertical spread and that one leg I’m sure I really have no control over whether or not the holder of the option exercises early. And I get assigned.

But besides early assignments, a lot of option traders really don’t hold their positions  until expiration. They’ll voluntarily close them out at some point leading up to it, or roll it or whatever they want to do. Can an option profit calculator signal the best time to close out of position?

Dmitry Pargamanik

I don’t know if it could tell you what the best time, not the best time to close out of the the position, but by generating a payout diagram, you could kind of make better decisions where the potential reward that I have left to gain at this point may not be worth the potential risk that I’m taking off. So it would help kind of guide with those types of decisions, but it doesn’t know the best time to close out of a position because it does not know what the future outcomes are.

Jeff Praissman

We just finished up a great webinar and in this podcast we’re taking a little bit of a deeper dive. But are there any last thoughts you’d like to leave our listeners with regarding option pricing and option profit calculators?

Dmitry Pargamanik

Yeah, I think that one thought is that we often see many people when they first start trading and they get access to an execution system, that they’re so excited they jump right into the execution part.

And in their mind the risk management or risk evaluation happens after the execution. I’ll think about it later when the position’s going against me. But risk management always starts prior to execution. Pre-trade and then it’s ongoing because then you’re managing your existing risk.

So it’s not waiting for something bad to happen. Jumping into an execution waiting for something to happen, and then think about, well, how do I manage my way out of this? Because at that point, it’s too late.

So I think that one of the things maybe that people do overlook and it’s extremely important is to make a good valuation of your risk prior to even entering the trade so you understand your risk exposure. And you understand your risk reward and you’ll understand more the sensitivity of different variables to your positions and how to manage it and mitigate those risks.

So risk assessment, I think it always starts before the trade and it’s always ongoing, even while you’re in a position. So I think that’s an important thing for some people, especially first entering trading to understand.

Jeff Praissman

Will and Dmitry, thank you guys so much for coming by. It’s always great to have you in the studio. And for our listeners, for more from Market Chameleon, just go to ibkr.com, click on Education, then IBKR Campus and select IBKR Campus Contributors.

Again, thank you guys for listening. Until next time, I’m Jeff Praissman.

Related Webinar:  https://ibkrcampus.com/webinars/how-to-use-an-options-profit-calculator/

Contact Information: https://marketchameleon.com/