Whether we realize it or not, we are constantly making calculated decisions based on risk. From taking a certain route to work every day, trying new foods we have never tasted, or spending money on one item at Target in sacrifice for another, we are making these decisions while keeping in mind a balance of risk and reward. This kind of thinking is so important in the stock market and ultimately separates trading from gambling. I’ve mentioned in other articles how I only enter trades with a calculated risk/reward of at least 3:1. This means that for every dollar I am risking, I have the potential to make three. Options are a great way to maximize risk/reward ratios because not much principal is required to make a huge gain. If you don’t know what options are, check out my article, “Great Returns Investing Little of Your Money.” I have made option trades in which my returns were 200%! In this article, I’m going to be explaining a great tool that allows you to know the profit potential of any option trade.
Thinks or Swim
TD Ameritrade’s Think or Swim platform has a great analyze tool which allows you to run simulations on options based off of the strike price, expiration date, and your investment. You can literally see the dollar figure you would make if a stock moved up or down in an allotted time frame. It is truly a great resource.
Running these hypotheticals allows me to see the stocks with the risk/reward ratio I’m looking for or higher. I choose the highest risk/reward ratios to pick the stocks I will be invested in. For example, let’s say I have screened for stocks and found a cheap call option on a stock that has a nice wedge forming. I run the hypotheticals and find out that if I invest only $100 dollars into the trade, I have the potential to make $1000 if the stock goes up by 10% in 2 months. That is a 10:1 risk reward ratio. The MOST money I could lose is $100 and I’m risking that to make 10x as much.
Setting it Up
The Think or Swim platform is FREE and there are no account minimums so there is no reason you should not download the application.
- Take this link to get now: ThinkorSwim.
- Once you get in find the Analyze Tab at the top of the page.
- Then click +Add Simulated Trades
- Type in the Ticker Symbol of the Underlying Stock
- Option Chains on the stock will appear
- Select the option chain you want to trade
- Toggle at the bottom of the page to adjust
- Calls vs Puts
- Contract Price
- Toggle Price/Percentage moves in the stock to see what kind of reward you would be looking at within a certain time frame
No matter what option strategy you have, I highly encourage you to use this tool before you ever get into a trade. Be realistic and only go into the trade if you have a positive risk/reward. (Never settle for 1:1!)
Homework: Download the platform and start playing with the tool to get a better understanding of how to use it in the future.