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Option profit/loss diagrams visually represent an option strategy’s profits or losses as the different inputs into the pricing model change. As you dive deeper into more complex options strategies with multiple buying and selling options, these diagrams will be the key to seeing how to profit from time decay and volatility (factors unrelated to stock direction).
In this article, we’ll show you how to read a profit/loss diagram using examples.
This diagram represents a long call option at expiration. The vertical axis represents your profit and loss zones. The area above the zero line represents profit, and the area below the zero line represents loss. The horizontal axis represents the stock price, with stock price increasing towards the right and decreasing towards the left.
The blue line represents the strategy’s profit and loss; its shape varies depending on the strategy. The orange tick mark where the strategy line intersects the stock price line represents the “break-even” point. This is the stock price at which you would neither lose nor make any money. You could also think of it as the threshold at which you start making or losing money on a trade.
As a refresher, buying a call option gives you the right, but not the obligation to buy 100 shares of stock at any time at or before the contract expires. In exchange for this right, you pay the call seller a premium. That premium amount is the maximum that you can potentially lose on the trade. In the diagram, this potential loss is represented by the portion of the blue line which is below the zero line. As you move to the left on the diagram, that blue line is flat; the loss is capped at what you paid for the call contract and the loss does not increase as the stock price decreases.
A long call option makes money when the stock price goes higher. This is represented by the blue upward sloping line as the stock price increases. Past the break-even point, the blue line will continue to slant upwards as the stock price increases. This strategy has an unlimited upside potential as long as the stock price continues to increase.
Here’s what a short call option looks like:
A short call option is the exact inverse of the long call diagram—it’s just flipped along the horizontal axis. In a short call option strategy, you sell a call option to the option buyer. In this scenario, you sell someone else the right to buy stock at a given price at or before expiration, and the option buyer gives you a premium in exchange for the agreement.
As visible in the diagram, the profit potential of this strategy is capped at the premium paid by the option buyer. As long as the stock price stays below the break-even point (orange tick mark), the call seller makes a profit. However, as the stock price continues to increase, the call seller will soon take on losses.
To compare any long versus short (buying versus selling) options strategies, simply take the profit/loss diagram for one strategy and to flip it along the horizontal axis. The resulting diagram will show you the profit/loss areas for the opposite strategy.
Here is a sample of other option profit/loss diagrams for other options trading strategies:
Long calls, short calls, long puts, and short puts are the four basic building blocks for any options strategy. All other options strategies revolve around different combinations of these four positions.
For example, here is an iron condor strategy:
This strategy is a mixture of selling a call option, buying a call option, selling a put option, and buying a put option – all at the same time. What’s unique about this strategy is that it profits in a limited range. This is a neutral market strategy, meaning you wouldn’t want the stock price to go higher or lower, but rather to stay in a predefined range (between the two orange marks in the diagram). If the stock price increases or decreases too far, the strategy begins to lose money.
This is how a profit/loss diagram might look in a brokerage platform:
Here we can see similar characteristics of the previous examples. Along the horizontal axis is a list of stock prices ranging from $30 on the left, all the way to $52 on the right. The vertical axis shows the dollar amount of the potential profit or loss. The red hash marks indicate the break-even prices for this particular strategy.
Like in the previous diagrams, the light blue line here represents profit/loss at expiration. The purple line, meanwhile, shows the profit/loss today. The difference between the purple line (today) and the blue line (at expiration) is the time value or extrinsic value of the options.
As time goes by and volatility decreases, the purple line showing the immediate profit/loss tends to slowly move higher, eventually matching the blue line. This is helpful information; even though the purple line might show a loss on a trade today (e.g. the diagram shows a loss of around $50 with a stock price at $42), at expiration, we can see that this strategy actually shows a profit of around $50. As long as the stock price doesn’t change, knowing this information can give you more confidence that you will eventually make a profit as time goes by.
All options strategies are comprised of four building blocks (long call, short call, long put, and short put). Once you start combining multiple options contracts into one strategy, understanding when and how the strategy will make or lose money can become difficult. Option profit/loss diagrams visually represent possible outcomes; learning how to read them is an essential tool to use to understand more complex options strategies – where and when they make money, lose money, or break even.
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