Lesson 09 – Option Profit and Loss (P&L) Charts

Lesson Objective: Understanding how option Profit & Loss (P&L) charts provide the risk and reward profile of option strategies

Option P&L charts (also called diagrams or graphs) are an easy and quick way to visually comprehend the risk and reward profile of an option strategy. It is a representation of the possible profit and loss outcomes of an option strategy at a given point in time, often at expiration.

The price of the underlying/stock is indicated on the x-axis (abscissa) and the P&L on the y-axis (ordinate) of the chart. This type of chart also shows you at a glance where you breakeven: at price(s) where the P&L line meets the x-axis. Any value plotted above the x-axis would represent a gain (the green section below); any value plotted below would indicate a loss (the red section below). Check the P&L chart at expiration of a long call below:

As you can see immediately, if the underlying trades under $102 at expiration you lose money, above $102 you make money, and at $102 you breakeven.

We always recommend that you check the P&L chart of an option strategy before you submit an order to trade. This will provide you with a clear picture of the conditions under which you will end up making a profit or not. Most options trading platforms, brokers, and options simulators/calculators provide you with P&L charts for specific option strategies.

However, beware that these charts do not tell the whole story of an option strategy. For instance, they give no indication of the current volatility of the underlying, nor do they take into account the timing of the trade entry (e.g., before an earnings announcement). So, when comparing two option strategies  (say “A” and “B”) with the same underlying, you could be misled into believing that strategy A has a better risk/reward profile than strategy B based solely on their P&L diagrams -when in actual fact the likelihood of strategy A being successful is actually significantly less than for strategy B given the specific market conditions of the particular underlying you are contemplating trading. Let’s consider two examples below:

A) You buy one At-The-Money (ATM) Call and one ATM Put on stock XYZ for the same expiration date and same strike price (assume $100) for a total cost of $2 per share: this is called a long Straddle (we will discuss Straddles in detail in a subsequent module). Your P&L diagram will look like this:

As you can see your profit is potentially unlimited while your losses are limited to $2 per share. Looks good so far.

B) Now, you sell the exact same straddle instead (you are short the straddle), so your P&L diagram looks like this:

The situation and graph have been reversed: your profit is limited while your losses are potentially unlimited.

You may wonder now why anyone would choose B over A given the P&L profile of B. The answer lies in the specific market conditions at the time you are considering entering the trade.

For instance, if the underlying is perceived as being very volatile at the time you want to buy the straddle (i.e., its “implied volatility” is high, which means that the market is expecting more movement in the price of the underlying in the future in comparison to its historical level) then it is more likely than not that such volatility will decrease due to mean reversion (theory which suggests that an economic indicator will tend to move towards its historical average or mean over time).

Because the price of an option is greater when implied volatility is higher (we will discuss this concept in detail in a later module), the price of your straddle would be inflated at the time of purchase and would more likely than not decrease due to implied volatility reverting to its mean (all else being equal) meaning that your long straddle would lose value. This is the reason why a high implied volatility environment is usually not ideal for a long straddle and more favourable for short straddles in spite of what the P&L graph suggests.

Each option strategy – such as the short and long straddles we just discussed – has a typical P&L chart that characterizes the profit and loss potential for that particular strategy (it is like a signature). Recognizing the typical signature of a particular strategy helps you visualize whether or not you have entered the intended strategy or not, so it is always helpful to have at least a general idea of the main option strategy graphs. The figure below, taken from the Options Industry Council’s website, shows various options strategies and their corresponding P&L diagrams.

Source: Options Industry Council

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