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This series of articles has covered the use of the Option Payoff Graph as a trade analysis tool for option trades. This final article in this series will examine how the option payoff graph depicts possible changes in market expectations, otherwise known as Implied Volatility. I should say here that the bullish case for GE did not look nearly as strong on February 10 as it had when we first suggested it on January But the stock did not take the kind of bounce that we were hoping for.
This is not surprising since the general market direction has been very bearish. They had 36 days until expiration. They demonstrate how we can visualize the profit picture at different dates in the future, at any price for the stock. The red line is how things looked on Feb 10, with 36 days to go.
The green line is how they would look 12 days later, the blue line 12 days after that and the gray line as of the expiration date on March All of those lines were drawn assuming that the expectations of volatility for the stock remained unchanged. This is the default assumption. But we also would like to know how things would be affected by a change in expectations. How much more would they be charging us to buy those options back in that case?
How much cheaper would those options be? The payoff graph can help us with this part of the trade analysis as well. By working those changes in assumptions into the payoff graph, we can see the subtle differences in the projected outcome. Compare the payoff graphs below to the first one:. Notice above that all of the curved lines are higher at every stock price — a reduction in volatility after we have sold puts and pocketed the money increases our profit. Here, on the other hand, we see how an increase in volatility would reduce our profits at any date and stock price.
That is because if volatility increased, the price we might have to pay to buy the option back and terminate the trade would increase, reducing our profit.
If we had a strong expectation that the level of implied volatility would either rise because it was abnormally low or fall because it was abnormally high , then being able to model those expected changes would allow us to quantify the effect. For option traders, the effort spent learning to use this invaluable trade analysis tool is well worth it.
Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein.
Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.