# Measure Profit Potential With Options Risk Graphs

Trading options may seem complicated, but there are tools available that can simplify the task. For example, modern hardware can take care of the fairly complex mathematics required to calculate the fair value of an option. To trade options successfully, investors must have a thorough understanding of the potential profit and risk for any trade they are considering. For this, the main tool option traders use is called a risk graph.

The risk graph, often called a "profit/loss diagram," provides an easy way to understand the effect of what may happen to an option or any complex option position in the future. Risk graphs allow you to see on a single picture your maximum profit potential as well as the areas of greatest risk. The ability to read and understand risk graphs is a critical skill for anyone who wants to trade options.

## Creating a Two-Dimensional Risk Graph

Let's begin by showing how to create a simple risk graph of a long position in the underlying—say 100 shares of stock priced at $50 a share. With this position, you would make$100 of profit for every one-dollar increase in the price of the stock over and above your cost basis. For every one-dollar drop below your cost, you would lose $100. This risk/reward profile is easy to show in a table: Investopedia / Sabrina Jiang To display this profile visually, you simply take the numbers from the table and plot them in the graph. The horizontal axis (the x-axis) represents the stock prices, labeled in ascending order. The vertical axis (the y-axis) represents the possible profit (and loss) figures for this position. Here is the two-dimensional picture that is produced: Investopedia / Sabrina Jiang To read the chart, you just look at any stock price along the horizontal axis, say$55, and then move straight up until you hit the blue profit/loss line. In this case, the point lines up with $500 on the vertical axis to the left, displaying that at a stock price of$55 you would have a profit of $500. The risk graph allows you to grasp a lot of information by looking at a simple picture. For example, we know at a glance that the break-even point is at$50—the point where the profit/loss line crosses zero. The picture also demonstrates immediately that as the stock price moves down, your losses get larger and larger until the stock price hits zero, where you would lose all your money. On the upside, as the stock price goes up, your profit continues to increase with theoretically unlimited profit potential.

## Options and Time-Based Risk

Creating a risk graph for option trades includes all the same principles we just covered. The vertical axis is profit/loss, while the horizontal axis shows the prices of the underlying stock. You simply need to calculate the profit or loss at each price, place the appropriate point in the graph, and then draw a line to connect the dots.

Unfortunately, when analyzing options, it is only that simple if you are entering an option position on the day the option(s) expire, when determining your potential profit or loss is just a matter of comparing the strike price of the option(s) to the stock price. But at any other time between the date of entering the position and expiration day, there are factors other than the price of the stock that can have a big effect on the value of an option.

One crucial factor is time. In the stock example above, it makes no difference whether the stock goes up to $55 tomorrow or a year from now—regardless of time, your profit would be$500. But an option is a wasting asset. For every day that passes, an option is worth a little less (all else being equal). That means the element of time makes the risk graph for any option position much more complex.

On a two-dimensional graph displaying an option position, there are normally several different lines, each representing the performance of your position at different projected dates. Here is the risk graph for a simple option position, a long call, to show how it differs from the risk graph we drew for the stock.