Stocks Introduction to profit-loss diagrams Diagrams aren't just horrible, boring torture devices drawn by old Econ teachers on screechy chalkboards.
We've been there. For options, profit-loss diagrams are simple tools to help you understand and analyze option strategies before investing.
When completed, a profit-loss diagram shows the profit potential, risk potential and breakeven point of a potential option play. They're drawn on grids, with the horizontal axis representing a range of loss option prices that the underlying stock could go to and the vertical axis representing the corresponding profit or loss for the option investor on a per-share basis.
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Graphing stock Let's warm up with a basic profit-loss diagram of a normal, purchased stock, because this will get us loose before diving into options diagrams. Below graph 1 is a diagram of long stock.
The term "long" means that the stock was purchased. Graphing a long call That was easy.
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Now let's look at a long call. The horizontal line to the left of 40, the strike price, illustrates that loss.
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To the right of 40, the profit-loss line slopes up and to the right. Losses are incurred until the long call line crosses the horizontal axis, which is the stock price at which the strategy breaks even.
Above Note that the diagram is drawn on a per-share basis and commissions are not included. Graphing a short call Now for the third example—a short call. Therefore, a short call has unlimited risk, because the stock price can rise indefinitely.
Double Calendar Option Strategies Options are derivative products that allow investors to leverage a high level of stock without having to come up with a large amount of capital and actually purchase the stock itself. Purchasers of call options can take advantage of stock moves without an equal amount of risk, and they can play loss option strategies that can fully realize the potential of a market upswing or protect against a downswing.
The profit potential, however, is limited to the premium received when the call was sold. To the right of 40, the profit-loss line slopes down and to the right. Profits are earned until the short call line crosses the horizontal axis, which is the stock price at which the strategy breaks loss option.
These diagrams help investors in several ways, by: Visualizing a strategy Revealing profit potential, risk, and the break-even point Enabling comparisons to other strategies You see? That wasn't so bad.
Homework is optional in this class, but with a little practice you can learn to draw profit-loss diagrams and start your life as an options investor. Next steps to consider.
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