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 stock prices that the option chart 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.
- The green and red candles show how the action played out on the charts, and let you know if you should buy or sell.
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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. Now let's look at a long call. The make your computer make money 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 the option chart 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.
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.
You decide to try and capture some of that upside with an options play. It turns out you can. Are those prices fair or a little steep? To answer this question, it would help to see how the option has moved in the past. You can chart an option just like a stock.
Profits are earned until the short call option chart crosses the horizontal axis, which is the stock price at which the strategy breaks even. These diagrams help investors in several ways, by: Visualizing a strategy Revealing profit potential, risk, and the break-even point Enabling comparisons option chart other strategies You see?
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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.