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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 option curves representing a range of stock 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.
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.
Each Greek measures how portfolio's react to minor alterations in a particular underlying factor, allowing individual risks to be examined. This offers a means of calculating leverage, which may also be referred to as gearing. Vega is the measure of the option's worth in regard to the volatility of the underlying asset. Rho appraises reactivity of the option value to the interest rate: it is the measure of the option value with respect to the risk-free interest rate. The opposite of this is also the case, in that a shorter period of time before expiration is apt to create a drop in the value of option curves call and put options.
Now let's look at a long call. The horizontal line to the left of 40, the strike price, illustrates that loss.
To the right of 40, the profit-loss line slopes up and to the right. Losses are incurred until option curves long call line crosses the horizontal axis, which is the stock price at which the strategy breaks even.
Vol Curves and Vanna Charm with Cem Karsan
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.
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Therefore, a short call has unlimited risk, because the stock price can rise indefinitely. 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 even.
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. 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. The horizontal axis the x-axis represents the stock prices, labeled in ascending order.
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.