Are Options Profit Calculators Accurate?

When using an Options Profit Calculator, it’s crucial to understand how these calculators work and how their assumptions impact their accuracy. The P/L shown by calculators before expiry is rarely the exact P/L you’ll realize in the future, and understanding how factors like Implied Volatility (IV) and interest rates affect these calculations is a prerequisite for properly analyzing your trades.

After a brief introduction to pricing models and their main inputs, we’ll dive into a few examples and look at why these inputs can change dramatically and alter your return profile. After reading this article, you’ll have a better understanding of how options profit calculators work and how to effectively use them to evaluate your trades.

Option pricing models and their inputs

Every options calculator uses an option pricing model to estimate how much an option contract is worth given its duration, strike, underlying price, IV, dividends and the risk-free rate. Put another way, an option pricing model is a mathematical model that estimates an option’s value based on those factors.

As a first step, option calculators derive the IV using their model. All other inputs and the option’s market price are known, so the contract’s current IV can be calculated using the model, as it’s the only unknown in the equation.

When projecting the future value of an option contract at a given point in time and for a given underlying price, calculators assume the contract’s IV, the risk-free interest rate and the dividends stay the same. This means all the inputs to the model are known, and the option’s value can be computed using the model.

But assuming those inputs stay the same is a huge leap of faith and the main source of divergence between the calculator’s projections and actual realized outcomes. Option prices, like anything else, are driven by supply and demand. We calculated the IV using current prices, but the market is unlikely to price the option at the exact same IV in the future, so the calculated value can also be wrong.

Interest rates and dividends can also change, but their impact is usually minuscule compared to variations in implied volatility.

Note that this only applies when looking at P/L before expiry. At expiry, there’s no more time value left in options, their payoff is deterministic, and calculators can display it accurately.

Earnings announcements drive IV up

Stock prices can move a lot in either direction after earnings are announced. That means option contracts expiring after the announcement have the potential to end up deep in the money and are generally worth much more than contracts expiring right before the announcement.

But the option pricing model doesn’t take earnings into account. It doesn’t know that a 7-day-to-expiry (DTE) option expiring after earnings is worth much more than a 6DTE option expiring before, and just sees that the market is pricing the 7DTE contract at a much higher IV.

If you buy a 7DTE option on a stock that announces earnings the next day, once the effect of the earnings announcement on the stock price settles down, your now 6DTE contract no longer spans the earnings announcement that was driving up its IV, and therefore loses a significant amount of its value. Generally, option contracts expiring after earnings gradually increase in IV leading up to the announcement, and then suddenly drop afterward. This is known as IV crush.

Since options profit calculators don’t take IV crush into account, the values they show after earnings can overestimate option prices. You should decrease the modeled IV in the calculator to get a better estimate of your strategy’s P/L.

Pro tip: Use GammaWins’ free Volatility History to see what option contracts of different maturities and moneyness were worth in the past before and after earnings, and get a better sense of the IV range for the contract you are looking at.

Macro and political uncertainty

Macro-economic announcements like central bank interest rate decisions, unemployment data and inflation reports can also cause markets to move suddenly. Major political events like elections and wars can also increase uncertainty and make option contracts more valuable as the range of possible outcomes widens.

These factors can have a similar effect on ETF and index options exposed to them. Individual stocks can also be impacted, especially if the underlying business is likely to be affected by the event or uncertainty.

VIX is a great measure of this kind of volatility. It’s a 30-day expected volatility measure derived from SPX option prices and therefore tends to move up as uncertainty increases in the market. Note that VIX is not a good measure of volatility for events that don’t impact the index like individual stock earnings announcements or uncertainty that is unlikely to affect the US stock market.

Just like IV crush, a calculator doesn’t take the decrease in IV once the uncertainty is resolved into account, and therefore can overestimate option prices after announcements. On the other hand, sudden unexpected events that make the markets more uncertain can drive IV up, and therefore you should evaluate your strategy with higher IVs to see how it behaves under such conditions.

IV smile

In equity options, it’s very common for out-of-the-money (OTM) put options to have higher IV, which generally increases as you go further OTM. IV generally decreases for slightly OTM calls, but can start increasing again as you go further OTM, although to a lesser extent than for OTM puts. This is known as IV skew or IV smile, as plotting IV across different strikes can produce a smile-like shape.

As the underlying price changes, option contracts can end up at a different part of the smile and change in IV. This can for example cause a put contract’s IV to increase as the underlying price rises. The put contract becomes less valuable, but can still be priced at a higher implied volatility.

Note that the volatility smile is not a static shape and is also driven by supply and demand at different strikes. But as a general rule, a calculator’s estimates become less certain when the underlying price moves and pushes option contracts to different parts of the smile.

IV term structure

Option contracts with similar strikes and different expiries also generally don’t have the same IV across the board. As a general rule, short-dated options have a much wider range of IV than longer-dated ones. When IV is low across the board, short-dated options usually have lower IV than long-dated ones, whereas in times of uncertainty, short-dated IV tends to jump much higher than long-dated IV.

A calculator doesn’t take any of that into account. You might buy a long-dated option when IV is low and the VIX is at historical lows. But if IV stays low and the term structure remains similar, your contract’s IV is likely to decrease over time, causing it to lose more value than the calculator would suggest with its fixed IV assumption.

Multi-expiry trades

Trades with contracts across multiple expiry dates are especially susceptible to these IV mismatches. The IV of different expiries can and often does move independently. This means not only can the IV of each expiry move over time, but the relative difference between them can also change.

A lot of calculators only allow you to adjust the IV for all contracts at once. But reality rarely works like that and to get a realistic view of what can happen with those trades, you should move them independently to some extent and see what happens if the IV of different expiries moves in different directions.

Market data

Another reason some calculators can produce misleading estimates and even incorrect option prices is their market data. Access to market bid/ask quotes is expensive and to reduce costs, some calculators rely on synthetic option prices modelled by third parties rather than data from the exchanges. While these synthetic prices can be close to fair value for more liquid options, they can also be way off when market prices don’t fit the models used by those third parties.

A calculator relying on inaccurate market data can produce outputs that are detached from reality, and even basic metrics like the entry debit or credit can be off by large amounts.

Good to know: GammaWins Calculator always uses accurate bid/ask quotes from the exchanges.

Interest rates

While interest rates usually have a small impact on short-dated and near-the-money contracts, they start to matter a bit more for ITM LEAPS. The value of these contracts can move with changes in interest rates. An options calculator generally assumes the interest rate stays the same, while more sophisticated ones like the GammaWins Calculator use the current yield curve to model interest rates at different maturities. But they cannot predict future interest rates, and they generally don’t allow you to tweak interest rate assumptions. This can make accurately modeling the impact of interest rates challenging.

Conclusion

Options Profit Calculators are indispensable tools for building option trades. They help you choose the right trade to express your view on the market and understand whether it fits your expectations for where the market is likely to end up. Their accuracy, however, is entirely dependent on their assumptions, the most important of which is the implied volatility. Understanding how IV impacts their output and what factors drive it is crucial to getting the most out of these tools.