What Is Profit Range?
Profit range refers to the range of possible profitable outcomes for a given trade or investment. Certain strategies have a limited range of outcomes, making it useful for traders to calculate their maximum profits or losses.
Profit range is particularly useful for options trades, where there may be a downward breakeven point as well as an upward breakeven point. The difference between the two points is known as the profit range.
- Profit range refers to the range of prices within which an investment position returns a profit.
- Certain strategies will determine the downside breakeven point and an upside breakeven point for a given investment position. The range between the two points is known as the profit range.
- Profit range is commonly used by derivatives traders, who use call and put options to limit their potential gains and losses.
Understanding Profit Range
Profit range can be described as the range of potentially profitable outcomes from a given investment position. Profit range is a helpful tool for investors, enabling them to compare against the volatility of an underlying asset when designing an investment strategy.
In most circumstances, solid investment strategies will match profit ranges with appropriate volatilities. Large profit ranges should usually be matched with high volatility assets, while smaller profit ranges should be paired with lower volatilities. Mismatches between volatility and profit range tend to lead to losses on a position.
The volatility of a security is associated with the amount of uncertainty or risk associated with the value of that security. A security with high volatility can change drastically over a short period of time, which can be attractive to investors looking for a fast, high return on investment. Risk-averse investors, on the other hand, generally prefer to play it safe with steady performing, lower volatility securities.
Profit range is commonly used by options investors because the gains or losses of these financial derivatives, which give buyers the right, but not the obligation, to buy or sell an underlying asset, are capped at a certain level.
Derivatives traders often use options to collar their trades, reducing both potential profits and losses.
How to Calculate Profit Range
A profit range hinges on determining the break-even points (BEPs) of an investment strategy. For stock or futures investors, a breakeven point is determined by comparing the market price of an asset to the cost of trading it, including fees and commissions. The breakeven point is reached when the two prices are equal.
Companies also use breakeven points to gauge their return on investment (ROI). In this case, the breakeven point is the point at which total revenue and total cost of doing business are equal, resulting in neither gain nor loss. Monitoring the breakeven point for a business has a number of useful strategic applications, including assessing capacity and maximum profits after expenses are covered, and determining the amount of loss a company can sustain in the event of a downturn.
A downside breakeven point is determined by the least desirable circumstances in regards to variable costs, while still remaining viable in the marketplace. In contrast, an upside breakeven point will be identified by the most desirable variable costs in relation to overall sales income. Profit range is established once the upside and downside breakeven points are defined, suggesting that in many cases the profit range is closely associated with the associated variable costs.
Example of Profit Range
For simple investments, the potential profit range can be unlimited. For example, if an investor buys a number of stock shares, the theoretical profit range can be infinite, since there is no upper limit to the price of a stock.
In other cases, the profit range can be limited. Imagine a stock whose current share value is $200, and a trader believes that the price could fall in the near future. That trader could buy an out-of-the-money put option for a premium of $1, and a strike price of $100, allowing the option holder to sell the stock at that price even if the market price falls lower.
In this case, the investor will break even if the stock price falls below $99, and any further drop will increase their profits. However, the maximum possible profit is $99 per share, because the share price cannot fall below zero. Since a put option includes 100 contracts, the profit range for this trade is between $0 and $9,900.
The calculation may be more complicated for more sophisticated investors, who may use both call and put options to collar trades and hedge against downside risk.