Even the most straightforward option, a long call, can be challenging to visualize and manage. Trying to keep a portfolio full of iron condors, long puts, bear call spreads, etc. without any help is a daunting task. Then, if you try to manage one of those positions by adjusting, you would be truly lost without some visual representation of what is happening.
An option's profit and loss graph, also known as risk graph, takes these very complex strategies and gives you a simple representation of what is happening and what is going to happen. We will discuss further why we need profit and loss graphs, how to read the graphs and the limitations of using them.
Why Do We Need Profit And Loss Graphs
Profit and loss graphs serve many purposes, but mainly they help us visualize how an options strategy will perform over a variety of prices. Before a position is placed, you can use these graphs and tell exactly what your profit and loss potential is for that strategy.
Not only can you see your overall gain and loss potential but you will be able to see how your position responds as the underlying moves across various price points.
One of the biggest benefits of a profit and loss graph is that you can see what happens when you try to adjust your position. Right now, visualize what happens when you have an iron condor on, and you adjust the position by buying a vertical put spread around your lower condor strikes. Do you know what that looks like? Can you tell what your new profit and loss potential would be?
Most traders couldn't visualize that adjustment let alone tell you their new profit and loss potential. Profit and loss graphs make that an easy task.
How To Read A Profit And Loss Graph
The graphs are broken down into two axis planes. The Y-axis, vertical or up and down, represents the profit and loss for the position. Any area above the X-axis shows us a profit and any area below the X-axis shows us a loss on the strategy. Some strategies will have a capped or limited profit or loss, and some will have an unlimited profit or loss.
The X-axis, horizontal or left and right, represents the price of our underlying. A profit and loss graph will typically show a small section of prices that affect our strategy starting with lower prices on the left and rising prices towards the right. Since our underlying can't go into negative territory, our X-axis will always begin at zero.
Our break even or break-evens for the strategy occurs at the price or prices anytime our strategy line crosses the X-axis.
Risk graphs can be created by hand, using software or through your [option brokerage](content: top 5 option brokerages). To make a graph by hand, you need to build a table of possible prices and what your profit and loss would be at each of those prices and then graph it out.
Let's say The Option Prophet (Sym: TOP) is trading for $30 and you want to purchase a call option at the 30 strike for $5.00.
From this straightforward table, you can begin to see how our graph is starting to come together. You can continue to plot your price points for the increments that you need and the prices you need.
Now, this is an option it is not the most effective way. A step up from writing out the table yourself is to use Excel and have your numbers computed by formula and then placed in a nice spiffy graph.
The easiest, fastest and the way you should be doing your profit and loss graphs is by using the tools your broker has given you. After all, that is why you are paying all of those steep commissions. A brokerage that does not offer profit and loss graphs to your positions and for necessary adjustments is not a good option brokerage.
The Limitations In Profit And Loss Graphs
Profit and loss graphs have several limitations that you need to be aware of. The first limitation is that the risk graph shows our profit and loss at the time of expiration, not before.
This is important for several reasons. Most beginning options traders see a profit and loss graph for their strategy and note the breakeven price or prices. Now, in their mind, this is the price their underlying must get to start making any money. If you hold your options to expiration, this is true, but it is not true if you are looking to trade in and out of the positions before expiration.
When you begin to add time into a risk graph the lines are no longer perfectly straight. Anytime you see a curve involved in the graph you know you are dealing with options over different time spans. This can make it difficult to understand exactly what your profit and loss will be at expiration because those numbers are ambiguous.
Another limitation and this one is minor is that profit and loss graphs don't account for commissions. Option commissions are small compared to regular trading commissions. As with any trading, however, everything must be taken into account when deciding on the best strategy. Some option strategies are commission intensive such as an iron condor and when you have to adjust the position this commission total can have a negative impact on your overall profit.
Option profit and loss, or risk graphs, are one of the most straightforward option concepts to grasp but they can have such an enormous impact on your overall trading success.
While you can always create your own profit and loss graphs, it is best to find a brokerage that will create graphs for you. By going through your brokerage, you should be able to easily map possible strategies, your current positions, and any adjustments you might make to your positions. Adjusting positions can be hard to see and understand their overall effect without a risk graph associated with them.