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 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 shares. The diagram in Figure 9 shows the potential profit and loss for this position. 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. With options, the diagram looks a bit different since your downside risk is limited to the premium you paid for the option.
Figure 11, taken from the Options Industry Council 's website, shows various options strategies and their corresponding profit and loss diagrams. In addition, the charts can be created by hand, by using spreadsheet software such as Microsoft Excel, or by purchasing commercially available analysis tools.
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Become a day trader. Black-Scholes Model Options Pricing: The Greeks Options Pricing: 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. A profit and loss diagram for a hypothetical stock this does not factor in any commissions or brokerage fees. A profit and loss diagram for a long option position.
Various profit and loss diagrams for different options strategies. Image is from the Options Industry Council website.
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