1. Options Pricing: Introduction
  2. Options Pricing: A Review Of Basic Terms
  3. Options Pricing: The Basics Of Pricing
  4. Options Pricing: Intrinsic Value And Time Value
  5. Options Pricing: Factors That Influence Option Price
  6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  7. Options Pricing: Modeling
  8. Options Pricing: Black-Scholes Model
  9. Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
  10. Options Pricing: Put/Call Parity
  11. Options Pricing: Profit And Loss Diagrams
  12. Options Pricing: The Greeks
  13. Options Pricing: Conclusion

A profit and loss diagram, or risk graph, is a visual representation of the possible profit and loss of an option strategy at a given point in time. Option traders use profit and loss diagrams to evaluate how a strategy may perform over a range of prices, thereby gaining an understanding of potential outcomes. Because of the visual nature of a diagram, traders can evaluate the potential profit and loss, and the risk and reward of the position, at a glance.

To create a profit and loss diagram, values are plotted along X and Y axes. The horizontal axis (the x-axis) shows the underlying prices, labeled in order with lower prices on the left and rising prices towards the right. The current underlying price is usually centered along this axis. The vertical axis (the y-axis) represents the potential profit and loss values for the position. The breakeven point (that indicates no profit and no loss) is usually centered on the y-axis, with profits shown above this point (higher along the y-axis) and losses below this point (lower on the axis). Figure 8 shows the basic structure of a profit and loss diagram.

The basic structure of a profit and loss diagram.
Figure 8: The basic structure of a profit and loss diagram. Any value plotted above the x-axis would represent a gain; any value plotted below would indicate a loss.

The graph line represents the potential profit and loss across the range of underlying prices. For simplicity, we'll begin by taking a look at a long stock position of 100 shares. Assume an investor has bought 100 shares of stock for $25 each, or a total cost of $2,500. The diagram in Figure 9 shows the potential profit and loss for this position. When the graph line is on $25 (the cost per share), note that the profit and loss value is $0.00 (breakeven). As the stock price moves higher, so does the profit; conversely, as the price moves lower, the losses increase. The figure shows the position breaks even at $25 (our purchase price) and as the stock's price increases (moving right along the x-axis) the profits correspondingly increase. Since there is, in theory, no upper limit to the stock's price, the graph line shows an arrow on one end.

A profit and loss diagram for a hypothetical stock.
Figure 9: A profit and loss diagram for a hypothetical stock (this does not factor in any commissions or brokerage fees).

With options, the diagram will look a bit different since our downside risk is limited to the premium that was paid for option. In this example, shown in Figure 10, a call option has a strike price of $50 and a $200 cost (for the contract). The downside risk is $200 - the premium paid. If the option expires worthless (for example, the stock price was $50 at expiration), the loss would be $200, as shown by the graph line interested the y-axis at a value of negative 200. The breakeven point would be a stock price of $52 at expiration; here, the investor has "lost" $200 by paying the premium and the stock's rising price is equal to a $200 gain, canceling out the premium. In this example, every $1 increase in the stock's price at expiration is equal to a $1 gain. For example, if the stock price rises to $54, it would represent a $200 profit.

Profit and loss diagram for a long option position.
Figure 10: A profit and loss diagram for a long option position.

It should be noted that the above example shows a typical graph line for a long call; each option strategy - such as long call butterflies and short straddles - has a "signature" profit and loss diagram that characterized the profit and loss potential for that particular strategy. Figure 11, taken from the Options Industry Council's Web site, shows various options strategies and the corresponding profit and loss diagrams.

Various profit and loss diagrams for different options strategies.
Figure 11: Various profit and loss diagrams for different options strategies. Image is from the Options Industry Council Web site.


Most options trading platforms and analysis software allow traders to create profit and loss diagrams for specified options. In addition, the charts can be created by hand, by using spreadsheet software such as Microsoft Excel, or by purchasing commercially available analysis tools.

Options Pricing: The Greeks

Related Articles
  1. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  2. Investing

    Risk Management Techniques For Shorting Call Options (IBM)

    Shorting covered calls is a popular options trade strategy. Here are the methods to mitigate the risk/loss and enhance profits for selling covered calls
  3. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  4. Trading

    Prices Plunging? Buy A Put!

    You can make money on a falling stock. Find out how going long on a put can lead to profits.
  5. Trading

    Strip Options: A Market Neutral Bearish Strategy

    Strip Options are market neutral trading strategies with profit potential on either side price movement, with a "bearish" skew.
  6. Trading

    When And How To Take Profits On Options

    Here are the different criteria to ensure maximum profit taking while trading options.
  7. Trading

    Options -- Accessing Stakes In Apple At Less Cost

    Finding Apple stock costly to trade? Here are multiple ways to trade it through low-cost Apple options.
  8. Trading

    Profit On Any Price Change With Long Straddles

    In this strategy, traders cash in when the underlying security rises - and when it falls.
  9. Trading

    Fix Broken Trades With The Repair Strategy

    You can recover from your losses if you know how to use this handy trader's tool.
  10. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center