Option profit & loss or payoff diagrams help us understand where our options strategies win or lose money at expiration based on different stock price points. It's also important that you understand how they work because they can help you build complex options strategies and adjust trades.
In this video, we're going to go through options profit and loss diagrams and graphs. Profit and loss diagrams help us understand where and when our option strategy makes money or loses money either today or at expiration.
They're really important to understand and to master, because it's the key element to seeing, to visually seeing where you make money and where you don't base on where the stock is.
Again, it's also important to understand how they work, because it can help you also build complex strategies that profit from the nondirectional movement of stock. We're going to look at a live example of a trade that I have going on right now, at least it's on at the time of this video, that shows you this real life case study and scenario.
Today we'll go through some graphical representations. These look really pretty. Then we'll look at my trading platform. It doesn't look as pretty in most broker platforms, but again, I think the concept is going to be easily transferrable over from one to another.
Here is your basic P and L diagram or graph that you might have. Again, this is a call option example, and basically what you're going to have is down the left-hand side, you're going to have profit and loss, and that's easy up and down vertically.
Then what you're going to have, is you're going to have some zero barriers, or stock price barrier that move laterally left and right on the chart. This is going to be your zero barriers for profit and loss, or your break even point might be something like here.
Your break even point on this graph or the point at which your payoff diagram crosses over into a profit potential zone from a loss, and this line or this representation here left, and right could be many different stock prices.
It means, hey look, if the stock price is here versus here at expiration, do you make money or do you lose money? That's basically what we're looking at. The line in the middle of the chart or the red line in our payoff diagram, this is your strategy P and L.
This tells you where you make money, how much money you make, and what stock price you need to see to make that amount of money by expiration. Again, everything is in here in this simple graph. Let's go through a couple more different examples. Again, this is a call option that we're looking at first.
This is a short call option, which is the complete inverse and opposite here of the long call option and in this case you can see now, and I took away all the wording and stuff like that so you can see the representation of what it's showing, but it's basically showing you that you profit anywhere here, and lower.
Meaning that wherever the stock price is from here, which is our break even point and lower, that is your zone that you potentially make money on. What this P and L diagram shows you is that with a short call option, your profit is limited to the credit that you received.
We know that from other videos that we've already gone through here in track one, that your short call options profit is limited to that credit that you received. Now you have potentially an unlimited amount of risk if the stock price continues to move higher and higher and higher.
Again, remember that this black line here in the middle of the graph, this is the current stock price. SP to designate that. That's the current stock price, either up or down basically where it moves.
This is an example of a short put option, so you can see how the diagram fundamentally shifts and changes based on the different strategies that we're going to choose.
In this case with the short put option, you want the stock to move higher. That caps your risk or our profit potential to the credit that you received in selling that short put option. Then basically your risk is limited to just the value of the stock from your strike price down to zero.
If the stock goes all the way down to zero, then you'd lose whatever amount of money you would lose based on the prices that you choose and the underlying stock price. Those are some basic building blocks. Those are your short calls, your short puts.
We also can use them to now start building complex strategies. In this case, this is a bullish call debit spread. This is a bullshit call debit spread, and we've got more video tutorials on this so you can see, but a bullish call debit spread, where you would be buying on call option here, and then selling another call option at a different strike price.
Again, we'll be talking more about complex options strategies that you can build, but now you can visually see how joining two options strategies together, basically you're joining this strategy, buying a call and then selling a call at a higher price. Now you have that combined strategy.
Now, this is what your payoff diagram looks like. Now you have limited risk to the downside and limited risk to the upside. This option strategy might be a little bit different for you. It might fit your risk profile and how you want to trade. It might be the type of strategy that profits from the directional move that you think the stock might have.
Again, we can even get more complex as we start to build out additional strategies. This case is a short iron condor and where we're only going to profit if the stock stays range bound.
This is a great example of trading non-directionally here, and how this profit and loss diagram here can show you that if the stock stays basically between your two breakeven points, which one is here and one is here, that you end up making money on expiration.
Okay, so the really, really, good example of how you can use these P and L diagrams to see where your potential risk and reward is.
Let's look at my thinkorswim platform here. We've got a trade up that we currently have to go in our live money real account, all of our live money real account stuff is all stuff that we publicly post and show to our pro and elite members.
This is a P and L diagram for an XOP strangle that we have. Now, in this case, you can see down here below that we have the two options that are showing and working.
This is live, real time at the time I'm recording this, so all of this stuff is going to move and shift and adjust, but you can see now that we are short 2 April 2016 26 puts that we sold each for $55 and we also short 2 April 2016 35 calls which we also sold for $27.
In this case, we are net option sellers across the board. We sold a put option contract at the 26 strike. You can see that's where the diagram and P and L diagram pivots. Notice how it pivots right there. Then we sold a call option at 35.
Again, you can notice how the call option diagram pivots and shifts right there. Very, very similar to what we did back here with the iron condor. You can see the iron condor has that same top half shape. It pivots and shifts at the same levels. We're selling a put option and then selling a call option on the top side.
Now, in our case with our thinkorswim platform, the P and L platform is on the left-hand side here. You can see, this is our running P and L. We've got our zero barrier which is here, so this is the zero point.
Anything basically below that level at expiration, we lose money. Anything above that level, we start to make money. You can see all the different values here for how much money we can make or lose. Now the actual stock that we're looking at like I said is XOP.
As a result, down here on the X axis you have the different stock prices. These are all the different stock prices that the stock may be trading between now and the future.
Again, it can kind of give you an idea of where the stock, or if the stock trades at X point, how much money you would make or lose at that point in expiration. All you have to do is find the intersection of the stock price and your P and L graph, and that shows you how much money you make or lose.
Now inside of thinkorswim, most of the time, and most broker platforms have this. It's not just thinkorswim, but that's the one that we use.
A lot of the other ones like Dough and TradeStation and all the other ones, Trade King, they all have very much the same thing, but mostly what they'll have is they'll have some dotted line or line representing the current stock price somewhere right in the middle of your payoff diagram.
In this case, the current stock price is $30.75. It might be hard to see unless you've maximized this video, but it's all record in HD so you should be able to see this. Currently, XOP is trading for $30.77 now because it's trading live time.
If we just visually go up this P and L graph here at $30.77, you can see that it now intersects with this green line, which is our payoff line for our strategy.
Now this green line is the expiration line for us, or is the payoff at expiration, meaning the end of the April cycle, whenever the April cycle fully goes through. Right now, as long as the stock stays basically between 26 on the put side, and 35 on the call side as far as a price, so the underlying security, we can make at expiration, about $164.
That's our max potential profit, is $164 on this particular trade. Now right now the trade is working out in our favor, and we're already making some money on this trade, but you can see that all we need this stock to do is stay between 26, which is here, and 35 on the top side and we make money, $164 at expiration.
If we go over to the chart here of XOP, you can see that 26 is here, and 35 is here. This is that type of strategy that I've talked about earlier in these videos, that we don't care where the stock goes. It could trade to 32, down to 27.
It could trade all over and all over this place and in this zone. As long as it stays between those two strike prices, then we have an opportunity to make a maximum amount of money on this particular trade.
Now let's say for example that the stock closed up around $37. This is where you can see where your risk is. Let's assume that the stock closes at expiration up around $37.
In that case, we would just take our 37 strikes, go up to wherever it intersects with our P and L chart, which you can see is right here, and then go left from there, and you can see that ad expiration.
If the stock were at $37, we would lose a little over $200 on this trade. If the stock moved all the way up to $37 at expiration, then we would lose about $200 on this trade. If it moved up to 38 at expiration, then we would lose about $450.
You can see how hopefully I'm just visually going left and right, up and down, based on stock price and my P and L diagram here. Hopefully, that makes sense. If you have questions, ask them in the comment box right below.
The last thing that you'll see on these P and L charts, at least on the thinkorswim chart, is you'll see this purple line here. Now, this purple line gets people a little bit confused, and the way that I traded is I'm always concerned about more so my P and L graph at expiration, which is this green line.
That's the money maker because that's the one that I'm concerned about if the trade has to go all the way through the expiration month. What this purple line shows, is this purple line shows your P and L today, so how much money you're making today based on the current stock price, implied volatility, and the market move that's happening.
What the difference is between basically the purple line and the green line, is the difference in time value or volatility value. Here's a good representation of how this works. Let's say for example, that the stock is, or let's just use the current stock price right now of $30.83.
You can see it's trading as we're doing this video. Currently, at $30.83 today, we have made $93.97 on this trade. That is the current profit that we are holding right now. If we wait and hold this thing between now and expiration, which is another 25 days away, then we can make another, basically $64 on this trade.
Remember our max return is about $64. We've already made about 100 bucks. That difference in this line shows you how much money you make or lose now versus at expiration.
Where it's helpful is in a situation like this where if the stock, let's say, for example, today XOP was trading at 26 versus 30.81. Let's say the new price suddenly was $26. Instantly you'd be losing on this trade about $100 today.
Your loss today would be $100. Now, if you were smart and you start looking at these option P and L charts and these diagrams, you'd realize that if the stock stayed there for the rest of the expiration cycle, you'd make your full profit if they stock stayed there.
It might either help you stay in or stay out of the trade obviously, but just know that your loss today at $100 is just today's loss. It's not how much you would lose at expiration trading this strategy. That might help you be more confident in how you trade that particular security.
Let's look at another example here. I want to look at DIA, and we're going to build a strategy here in DIA real quick. Just do a long call option in DIA. Again, you can see this P and L chart start to evolve and move. Now, this is a long call option.
Again, let's go back to our slides here. This is what this payoff diagram looks like for a long call option. Probably should have started with this one, but it's okay. I want to challenge you guys a little bit and hopefully get you a little bit faster into the options trading space.
In this case, again, our strike price for doing this long call option is the 176 strike. That's exactly where the P and L diagram pivots. Again, what we're concerned about is this green line here. That's our profit and loss at expiration right now.
The purple line is our P and L today. Now obviously if we enter the trade today, and the stock is trading right here, we can't make or lose money based on where the stock is trading now because we paid a premium to get into this trade. That's the premium that we paid here of $2.10.
Now you can see on the P and L chart on the left-hand side; our maximum maximum maximum risk is $210 on this trade. Even if the stock closed down to not 169, and it's currently trading at 175.93, even if the stock moved all the way down to 169, we'd still only lose $200.
If it moved down to 173, we'd lose $200. If it moved down to 175, we'd lose $200. You can see how this payoff diagram shows you where your risk is and not. Now, in this case, we also have to add the strike price, plus our debit that we paid to get into this contract.
We add these two things together, so the 176 plus the 208, and that gives us our new break even point here, basically at about 178 and change. Now we realize that the stock is trading here at 176, but we need the stock to trade above 178 for us to make money at expiration.
Again, if we were choosing to do the call options, then we are forcing the market to make a move at least up to 178 for us to make money at expiration. Again, this is our zero barrier here, this line right in the middle. This tells us how much money we make or lose at expiration.
Hopefully that was a really good example, again going through all of these P and L charts. Take your time and play around with some of these, whatever broker platform you use.
Go back through this video, head into the different video training modules that we have here at OptionAlpha and learn how these different P and L charts can affect different strategies because this is critical to your understanding of how we can build strategies that generate consistent monthly income.
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