In order to learn about options with maximum speed it's best to transform words and concepts into pictures.
Do you know what buying an asset like a stock or a future looks like? In order to find out, we need
to learn how to draw a Risk Profile Chart. This is the cornerstone on which we build far more complex
strategies, so it's important to understand this.
Unlike a standard price chart were the x axis represents time and the y axis represents price, a risk profile
chart is structured as follows:
Example - Consider buying a stock for $25.00:
- The X-axis represents the stock price, with the price rising as the line moves right.
- The Y-axis represents your profit/loss for the trade.
- The 45° diagonal line is your risk profile for the trade. As the price of the stock rises, so does your profit. So when the asset price rises to $50, you make $25 profit.
Long Stock Risk Profile Chart
Step 1: Y axis for profit / loss position
Step 2: X axis for underlying asset price range
Step 3: Breakeven line
Step 4: Risk Profile line
Now you can see what buying a stock looks like, let's look at what "shorting" a stock looks like.
Shorting just means selling something that you don't already own. Shorting is an accepted concept in some stock markets such as the US, but is not currently allowed in some other stock markets such as the UK.
Remember that when you short you can lose an unlimited amount as the asset price rises, and your maximum profit is the shorted price, here, let's say $25.00. In order to make maximum profit from a short stock position, the asset would have to fall to zero.
Short Stock Risk Profile
So, now you know how to draw the most basic risk charts, we can move to options risk profiles...
The importance of a risk profile chart becomes clearer when we look at options strategies.
Consider a call option:
A call option is the right, not the obligation, to buy an asset (eg a share) at a fixed price before a predetermined date.
Let's say we want to buy a call option to buy a stock at $25.00 (strike price) before December (expiration date) and we pay $3.50 (premium) for this option.
Call Option Risk Profile
A put option is the right, not the obligation, to sell an asset (eg a share) at a fixed price before a predetermined date.
Let's say we want to buy a put option to sell a stock at $25.00 (strike price) before December (expiration date) and we pay $3.50 (premium) for this option.
Put Option Risk Profile