Profiling Option Trades with Risk Graphs
Basic call and put option risk graphs are slightly different than stock risk graphs because they incorporate the risk and reward for the security, along with the breakeven level. Position-specific profiles will include stock prices on the x-axis and profits/losses on the y-axis. The profile also identifies the following:
The option strike price
The position breakeven
Although it’s less obvious when you’re viewing generic risk profiles, the main benefit of using options to limit losses can be viewed in these risk graphs.
A basic call option risk graph is similar to a long stock risk graph, with two important distinctions:
You need to account for the call option premium in the breakeven level.
Your losses are capped to the downside before a stock declines to zero.
The potential risk for a call option is limited, whereas the potential rewards are unlimited. This is displayed in the generic call option risk graph here.
The call option risk graph provides a picture of losses that are limited to the initial investment as the stock declines. This amount is much smaller than those for a long stock position. A call option allows unlimited profits that are similar to a long stock position, but must also account for the call option breakeven level.
A basic put option risk graph is similar to a short stock risk graph, with a couple of distinctions. The second one is extremely valuable if you’re bearish on a stock and things go against you:
You need to account for the put option premium in the breakeven level.
Your losses are capped to the upside and are therefore limited.
The potential risk for a put option is limited while the potential rewards are limited, but high. This is displayed by a generic put option risk graph here.
The put option risk graph provides a picture of losses that are limited to the initial investment as the stock rises. As a trader, you have to prefer this graph to the short stock profile, simply because your risk, although high, is limited. It also provides profits that are similar to a short stock position. The put risk graph also accounts for the put option breakeven level.
When you buy a put option, the most you can lose is your initial investment. Although that’s not your intention, you need to remember that this initial investment is much smaller than a short stock position which is also used when you have a bearish outlook for the stock.