Stan Freifeld

A Graph is Worth a Thousand Words

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By looking at the graphs, we can see if our potential gains and losses are limited or unlimited, and also tell if we want the stock to go up or down by expiration. Now you're probably thinking if someone needs a graph to tell if he wants the stock to go up or down, he probably shouldn't be trading options (or anything else for that matter.) Well, right now we're only looking at the most basic and simple positions.

Later on we'll look at some positions where it's not so obvious, or where perhaps in one range of stock prices we want the stock to go up and in another range, we want it to go down.

(Click here to see a larger version of this chart.)

(Click here to see a larger version of this chart.)

(Click here to see a larger version of this chart.)

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With a little thought, these graphs and their characteristics should become second nature.

For example, by looking at the graph of the long puts, we can see that there is almost (because stock can't go to less than 0) unlimited gain potential on the downside, breakeven with the stock at $47, and losses with the stock greater than $47. The maximum loss is the $3 that was paid for the option, and that occurs with the stock at $50 or above at expiration.

Note that these graphs are at expiration only. They are all straight lines and relatively easy to draw. Of course, we can also draw graphs prior to expiration and they will be useful for our risk analysis, but they are more complicated.

In my opinion, it is very important that you thoroughly understand these graphs, because the next step, which will be adding graphs together to come up with what's called "synthetic positions," is probably something that you haven't seen before.

Stan Freifeld is an instructor with the Online Trading Academy. To learn more about him, read his bio here

This article originally appeared on The Options Insider Web site.