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-Rubinstein 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 the X and Y axes. The horizontal axis (the x-axis) shows the underlying prices, labeled in order with lower prices on the left and higher 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 blue line (below) 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 buys 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 blue 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. 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 looks a bit different since your downside risk is limited to the premium you paid for the option. In the 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 blue line intersecting the y-axis at a value of negative 200. The breakeven point would be a stock price of $52 at expiration. In this case, the investor would "lose" $200 by paying the premium, which would be offset by the stock's rising price (equal to a $200 gain).

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 for a long call; each option strategy - such as long call butterflies and short straddles - has a "signature" profit and loss diagram that characterizes the profit and loss potential for that particular strategy. Figure 11, taken from the Options Industry Council's website, shows various options strategies and their 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 website.

Most options trading platforms and analysis software let you create profit and loss diagrams for specific 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

    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.
  2. Trading

    Options Risk Graphs: Visualizing Profit Potential

    With a single diagram, you can see how price, time and volatility affect potential gains.
  3. 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.
  4. 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.
  5. 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
  6. Trading

    The Basics of Options Profitability

    The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
  7. Trading

    Trade Covered Calls On High Dividend Paying Stocks

    We explain the risks, rewards, timing, and profit and loss considerations for covered calls with dividend stocks.
  8. Investing

    NYIF Instructor Series: Synthetic Stock

    In this short instructional video Anton Theunissen explains how to replicate a levered stock using a combination of options.
  9. Trading

    When And How To Take Profits On Options

    Here are the different criteria to ensure maximum profit taking while trading options.
Frequently Asked Questions
  1. When are Beneficiaries of a Will Notified?

    Learn when the beneficiaries of a will must be notified, and understand how this requirement varies depending on whether ...
  2. Why Does Larry Page Pay Himself a $1 Salary?

    Google co-founder Larry Page continues to take an annual salary of only $1 as chief executive officer.
  3. What is Common Stock and Preferred Stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ...
  4. Can CareCredit be Used for Family Members?

    Learn more about the available options that CareCredit offers to pay for out-of-pocket medical procedures with little to ...
Trading Center