Risk Graphs - Visualizing Your Profit Potential
Jim Graham

Trading options may seem complicated, but there are tools available that can simply the task enormously. For example, calculating what the fair value of any option should be requires fairly complex mathematics, but a computer and the right software will take care of most of that work nowadays. But 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 that option traders use is called a risk graph.   

The risk graph, often called a profit/loss diagram, gives you an easy way to understand what is likely to happen to an option, or any complex option position, in the future. Risk graphs allow you to instantly see your maximum profit potential, as well as the areas of greatest risk, by looking at a single picture. That makes the ability to read and understand risk graphs a critical skill for anyone that wants to trade options.

Creating a Two Dimensional Risk Graph

We will start at the beginning by showing how to create a risk graph using a position in the underlying – buying 100 shares of stock at $50 a share – as an example. With this position you would make $100 of profit for every one dollar increase in the price of the stock over and above your cost basis. For every one dollar drop below your cost, you would lose $100. This risk/reward profile is easy to show in a table.

 With the stock price at:  Your profit (loss) will be:
 $62.50  $1,250
 $60.00  $1,000
 $57.50  $750
 $55.00  $500
 $52.50  $250
 $50.00  $0 (the break even point)
 $47.50  -$250
 $45.00  -$500
 $42.50  -$750
 $40.00  -$1,000
 $37.50  -$1,250

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