When sizing up options trades, especially those triggered by a volatility signal (IVR, the VIX, etc...), most traders will do a rough calculation of the breakeven points for the proposed position.
In this sense, breakevens aren't necessarily a method by which traders filter for attractive opportunities, it's more of a way of "sanity-checking" a potential position. Basically another level of analysis which can help in the evaluation of a trade idea.
For example, if a trader notices that implied volatility in stock ABC is elevated, he/she might consider selling a straddle. Let's say for example that hypothetical stock ABC is currently trading for $50/share, and IVR in ABC is 90% with the VIX trading 35.
Assuming there's no binary events expected in ABC over the lifetime of the potential trade, a short premium trader certainly might consider initiating a short premium position in ABC. Now imagine that the trader looks at the closest to 45 days-to-expiration straddle in ABC and notices it is priced at $6.
Assuming that the position is traded without stock, that would mean the breakeven points when selling a short straddle in ABC with the stock trading $50/share would be $44 and $56. If the stock settles anywhere between that range ($44-$56) through expiration, than the trader makes a profit on the position.
If ABC settles exactly at $45 or $55 at expiration, then the trader breaks even on the position (i.e. the PnL is equal to $0). And if the stock settles below $45, or above $55, then the trader will take a loss on the position.
Now imagine that the trader looks at the last 4-5 months of trading and notices that the stock has ranged between $40 and $60 over that period. Given that level of historical movement, and the proposed breakeven points for the potential trade, the trader may elect not to deploy the position. In this case, the trader may find the IVR levels attractive, but find the actual break even points of the trade aren't that compelling.
On the other hand, if the trader looked back and saw that ABC had ranged between $47 and $53 during the last few months, he/she may be more comfortable with a $6 breakeven point for the straddle. In this second case, the implied volatility data, combined with the breakevens, may be enough to convince the trader that the position fits his/her strategy and outlook.
If you are looking to learn more about how break even points affect the analysis of potential trade ideas, then we suggest reviewing a recent episode of Trade Logic Unlocked. On this particular episode, the hosts explore two types of positions, ratio spreads and iron condors, and explain how the time horizon to profitability in these types of positions can be longer relative to other option structures.
Depending on your own unique risk profile and strategic approach, the information presented on Trade Logic Unlocked may help you better ascertain whether ratio spreads and iron condors may be appropriate in your portfolio.
If you want to learn more about breakeven points across a wide range of position types, you can always utilize the search functionality on the tastytrade homepage. Additionally, we have highlighted three great episodes focusing on breakevens taken from the tastytrade archives:
Should you have any outstanding questions on breakevens, or about a specific position, don’t hesitate to leave a message in the space below, or reach out directly to @tastytrade on Twitter or send an email to firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.