Successful options trading involves more than picking the right strategy; it also involves understanding the risks and rewards before making a trade. This is where options risk graphs come into play. They allow traders to visualize their profit potential, break-even points, and expectations of losing under different market conditions.
Risk graphs assist traders in understanding how changes in price, time, and volatility affect their positions. Whether you are using a simple call and put option or trading with complex spreads, knowing how to use risk graphs will give you a better chance of succeeding because of making the right choices at the correct times. Let us see how these charts work and how they can help maximize profit potential and manage risks.
Understanding Two-Dimensional Risk Graphs
A risk graph is a simple yet powerful tool visually representing how an options trade may perform based on the underlying asset’s price movement. It consists of two axes:
+ The X-axis (horizontal) represents the price of the underlying asset. This axis is labeled in ascending order from left to right.
+ Y-axis (vertical): Represents the potential profit or loss of the position.
To illustrate this, let’s start with a straightforward example: owning 100 shares of a stock priced at $60 per share. We can create a profit/loss graph by marking stock prices and plotting the corresponding gains or losses. The graph forms a straight upward-sloping line since every $1 change in the stock price results in a $100 profit or loss (because we own 100 shares).
When the stock price rises, the line moves upward, indicating increasing profits. When the stock price falls, the line moves downward, representing growing losses. The point where the line crosses the X-axis is the break-even price ($60 in this example).
However, with options, the graph doesn’t always follow a straight line. Since option prices are influenced by strike price, time to expiration, and option premium, their risk graphs take on more complex shapes. The following section will explore how different options and strategies create unique graph patterns and what they reveal about potential risks and rewards.
How To Read the Graph
To read a two-dimensional risk graph, identify the horizontal axis, which represents the stock price, and the vertical axis, which shows the potential profit or loss. Let’s say we’re analyzing a position with a stock price of $70. To determine the profit or loss at this price, locate $70 on the X-axis and move straight until you reach the profit/loss line. Then, check where this point aligns on the Y-axis. If it corresponds to 1000, it means that at a stock price of $70, you would have a $1000 profit.
The break-even point is where the profit/loss line crosses the X-axis. This is the price at which the trade neither gains nor loses money. If the break-even point is at $60, the position is profitable if the stock stays above this level.
Basic Risk Graphs
Long Call & Long Put
With a Long Call, the risk graph slopes upward to the right. As the underlying asset price increases, profits rise accordingly. Conversely, if the price declines or doesn’t rise enough, the maximum loss is limited to the option premium paid. The breakeven point is at strike price + option premium. To read this graph, look at the X-axis intersection to determine the cost needed for profitability.
A Long Put has a risk graph that slopes downward to the left. When the underlying asset price drops significantly, profits increase. If the price rises or doesn’t decline sufficiently, the maximum loss is also limited to the option premium paid. The breakeven point is at strike price – option premium.
Short Call & Short Put
For a Short Call, the profit/loss graph slopes downward to the right, indicating unlimited risk when the asset price surges. The maximum profit is the option premium received if the price does not exceed the strike price. The breakeven point is at strike price + option premium.
In contrast, a Short Put graph slopes upward to the left, showing significant risk if the asset price drops sharply. If the price increases or remains stable, the maximum profit is limited to the option premium received. The breakeven point is at strike price – option premium. This strategy carries a high risk in a bear market, so price movements should be monitored closely.
Covered Call & Protective Put
For a Covered Call, the graph slopes slightly upward to the left but flattens when the asset price rises. This indicates that profits are capped, even if the asset price increases significantly. If the price remains below the strike price, the investor still earns from the option premium and stock appreciation. However, if the price drops, losses may occur, though the option premium partially offsets them.
A Protective Put graph slopes upward to the right but levels off on the left. When the asset price declines, the put option limits the maximum loss. If the price increases, profits remain unlimited, as the investor still holds the stock. The breakeven point is at stock purchase price + option premium.
The Role of Time in Options Risk
Unlike stocks, where a price increase results in a fixed profit regardless of when it occurs, options are time-sensitive assets that gradually lose value as expiration approaches. If you evaluate an option position on expiration day, determining profit or loss is straightforward just compare the strike price to the stock price. But at any point before expiration, factors beyond stock price, such as time decay (theta decay) and implied volatility, can significantly impact an option’s value.
Over time, an option’s value steadily declines, but this process is not uniform. In the early stages, when expiration is still far off, the impact of time decay is minimal. However, as expiration nears, the decline speeds up.
Take, for example, a long call option with a $60 strike price, purchased for $2.50 per share (total cost: $250 for 100 shares). If the stock remains at $60 for the next 60 days, the option initially holds its full value. At the time of purchase, there is no profit or loss. But after 30 days, time decay causes the option’s value to drop, resulting in an estimated $65 loss. By expiration, if the stock is still at $60, the option becomes worthless, and the entire $250 investment is lost.
This illustrates the accelerating nature of time decay: the option loses about $65 in the first 30 days, but in the final 30 days, the remaining $185 disappears. The risk graph, with multiple time-based projections, visually highlights this accelerating decline and the significant role of time in option pricing.
The risk graph for this position includes three distinct lines, each reflecting potential profit or loss at different points in time:
The solid line (T+60): Represents the profit/loss at expiration. If the stock remains below $60, the option expires worthless, resulting in a complete loss of $250. The position becomes profitable if the stock rises above $62.50 (strike price + premium).
The blue line (T+30) shows the projected profit/loss 30 days before expiration. Even if the stock price remains unchanged, time decay has already reduced the option’s value.
The white line (T+0) represents the profit/loss at the time of purchase. Since the option still has 60 days until expiration, it retains its full value, making this the most optimistic scenario.
