As traders, it is prudent to model potential positions as part of ones due diligence prior to entering a particular trade.
With the aid of option simulation software, modeling can allow one to analyze all the relevant risks (delta, gamma, theta, vega) and understand the maximum loss and gain for any position over time.
The example used for this post is the 10-strike at-the-money August/September calendar spread for BAC.
Courtesy of Option Oracle, above is the theoretical payoff diagram for the position based on the price of BAC on August 20, the expiration day for front month of the spread. Furthermore, shown below, is the theoretical payoff diagram for the position based on varying volatility levels.
In this calendar spread example, the maximum risk, $19, is calculated as the net premium outlay for the position.
The maximum profit potential by August 20 is $19.70 per contract (103.66%). It is calculated based on ideal assumptions for the underlying and various Greeks. Specifically, it assumes volatility levels for each contract will remain constant at approximately 35% and that the position will remain delta neutral. Hence, it assumes there will be little price fluctuation. Consequently, because reality generally deviates from theory, it is highly recommended that sensitivity analysis be performed on all assumptions in any model.
Fortunately, option modeling programs like Option Oracle, allow one to do just that. As a cautionary concluding note, remember markets are dynamic and as a result, assumptions and decisions based on them must be constantly updated to maintain one's edge.
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