DEFINITION of Risk Graph
A risk graph is a two-dimensional graphical representation that displays the range of profit or loss possibilities for an option at various prices in the underlying asset. The x-axis represents the price of the underlying security and the y-axis represents the potential profit/loss. Often called a "profit/loss diagram or p&l graph", this graph provides an easy way to understand and visualize the effects of what may happen to an option under various situations.
Risk graphs can be drawn to show the potential payoffs for single options as well as for spreads or combination strategies.
BREAKING DOWN Risk Graph
The example below shows the risk graph for the profit or loss potential for a simple long call position of ABC Corp with 60 days until the expiration date, a strike price of $50.00, a contract size of 100 (shares), and a cost (premium) of $2.30 per share (for an initial outlay of $230 total).
Notice this graph includes three different curves, each of which represent the profit/loss possibilities at three different points in time. The dotted line is the profit/loss today, the semi-dotted line is the profit/loss 30 days from today, and the solid line is the profit/loss on the expiration date (60 days from today). As you can see, as time passes, the time value of the option decreases until it reaches zero, at which point the option-holder has a maximum loss of $230 (the cost of the option contract), which would occur if the option is not exercised. Thus, using these types of graphs, an option-holder can easily view his or her potential profit/loss at or before the expiration date. Also notice the green vertical line at $50.00, representing the strike price of the option, which forms an inflection point in the curve. If the option expires when the underlying ABC stock is less than $50, the option will expire worthless and the investor will lose the premium paid ($230 in all). If the stock finishes between $50 and $52.30, the trader will lose some of the premium paid.
Above $52.30, the investor has unlimited profit potential.
Risk graphs can also be constructed for short positions, or for complex strategies such as butterflies, straddle, condors, or vertical spreads. The risk graph below, for example, shows the potential payoffs for a 50 - 55 long call spread (also known as a bull vertical spread) in KC futures, where both the potential profit and loss from the strategy are capped.