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root strategies
How To Read A Risk Profile
Translating the different components of a risk chart
Probabilities
are marked as gray dotted lines (shown below). They correspond to the Option Delta values along the X-axis. The two inner lines represent one standard deviation. The two outer lines represent two standard deviations. Remember that one standard deviation is a zone where about 68% of random variations are expected to land. 32% of occurrences are expected to breach beyond the one standard deviation zone.
As you can see in this particular example, at the end of the timeframe, there is a 68% chance P/L will be within $3.50 in either direction. There is a 32% it could be greater than that. Not the most satisfying odds... In fact, there's a 30% chance this trade could be end up a $200 loser at the end of its timeline. This is estimated by aligning the 30Δ with the dollar amount, in this case -$2:
-$2 × 100 shares = -$200
Probability of Touch
(POT) is the probability that a particular price will be breached at least once during the life of the trade. POT is about two times the delta. This means that, while there's a 30% chance this position closes as a $200 loser, there's a 60% it will be down $200 or more at some point during the life of the trade. Options allow us to reduce these odds of losing, and reign in portfolio volatility. We won't get into option probability quite yet, but let's take a look at an option risk profile next! There are a couple noteworthy differences.