Drawing And Filling Out An Option Profit/Loss Graph

  1. Laying Out the Option Profit/Loss Graph

    Blank options profit/loss graph

    1. Take out a sheet of graph paper
    2. Label the horizontal axis Underlying Asset Price.
    3. Label the vertical axis Option Profit/Loss per Share
    4. Draw a horizontal line across the middle of the sheet, label it Break-Even
    5. Across the bottom of the page, label grid squares with numbers representing the SPY per-share price, with the $332 current price in the center, looking left to right.
  2. Plotting the Proposed Option Trade Entry

    Step 1 for filling out the option profit/loss graph

    On the graph, place a dot where the strike price ($330) and the amount paid for the option (-$3.00) intersect.
  3. Determining Loss if Price Is Below Strike Price at Expiration

    Step 3 for filling out the option profit/loss graph

    Since this option trade example is a call, we will extend a line horizontally from the dot to the left edge of the chart. This shows that, upon expiration, the loss would be equal to the amount paid for the option ($3), if at expiration the price was less than the $330 strike price by any amount ($0 – $330). If this trade were a put, the line would extend to the right edge of the chart to show that, upon expiration, the loss would be equal to the amount paid for the option, if at expiration the price was more than the strike price by any amount.
  4. Determining Potential Profit/Loss at Expiration

    Step 4 for filling out the option profit/loss graph

    For this call example, we will draw a line from the dot diagonally upward to the right. This line should run straight through the intersections in the grid lines, as shown. This shows that if the stock price is higher than the call strike at expiration, the call’s value will be equal to the amount by which the stock price exceeds the strike. If we had used a put, this line would be drawn diagonally upward to the left in the same fashion to determine the potential profit/loss.
  5. Reading the Option Profit/Loss Graph

    Step 5 for filling out the option profit/loss graph

    The finished graph above shows the following:
    • The maximum loss on any option purchase is the amount paid, and this maximum loss occurs on an option held until expiration if the stock price then is such that the option is worthless. This is conveyed by the horizontal line at -$3 P/L stretching from stock prices of $330 across to zero (although prices below $328 are not shown on the graph in this example).
    • This is a bullish trade – one that rewards an upward move in the stock price. This is conveyed by the upward slope of the diagonal line. Higher stock prices (farther to the right) equal higher profit potential, as indicated by the increase in price as the diagonal line moves upward.
    • Profit/loss can be determined by doing the following:
      • Draw a vertical line upward from the horizontal axis at any underlying asset price (price of SPY) at which you want to evaluate the trade’s profitability, say $333. This horizontal reference line you just drew is called a price slice. In practice, computers draw them for us.
      • From the point where the price slice intersects the blue diagonal line, draw a new horizontal line to the right, all the way to the vertical axis.
      • The value at which your newly-drawn horizontal line intersects with the vertical axis shows the profit or loss per share on the option trade, if the stock were to be at the price indicated at expiration.
      • Starting from an underlying asset price of $333, this process gives a value of $0 per share P/L. This indicates that if SPY is at $333 at expiration, the trade will break-even. A line drawn upward from $335 would intersect the P/L line at a P/L axis value of +$2.00, indicating a $2.00 profit, and so on.
    • Using the same logic, it is now easy to see that if the stock is at any price below $330 at expiration, the maximum loss of -$3.00 per share will be the result.
    • And, if the stock is between $330 and $333, there will be a loss on the trade of from $0 to -$3.00.
    • Finally, if the stock were to be at any price higher than $333, then there will be a profit on the trade, equal to the amount by which the stock exceeds $333, with no limit on profit.

    The construction of these graphs is elementary but very useful. This is just the beginning of what an option profit/loss graph can tell us. I hope that this step-by-step description makes learning how to use an option profit/loss graph easier.

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