Potential Profit and Loss on Your Option Strategy

In stock trading, if you go long on a stock, you might make a profit when the stock rises and lose money if it falls. The opposite is true if you go short.

Yet things seem to be more complex if you trade option strategies.

Today we'll walk you through a method generally used to analyze possible outcomes of an option strategy, which is the profit/loss, or P/L Chart.

Let's first look at an example.

(*The hypothetical example is for illustration purposes only and is not intended to represent the actual results of any specific investment, which will fluctuate in value. Fees are also not taken into consideration for ease of calculation.)

Suppose stock X is trading at $100. Eric buys a call option at $2 with a $110 strike price, and the contract multiplier is 100.

What are the possible outcomes for Eric on the option's expiration date? Let's consider the following scenarios. (*All the calculations below exclude commissions and other charges.)

First, the option will expire worthless if the stock price remains at or below the strike price of $110. This worst case scenario will incur the maximum loss, equal to the cost of buying the option, which is $200 (i.e., $2 * 100 shares).

Second, the break-even point will be reached if the stock price rises to $112. Eric might take advantage of the price rise and exercise the option, buying 100 shares of stock X at $110 and selling them immediately at $112. In this case, he will earn $200, which offsets the cost of buying the option.

Third, the option strategy will generate a profit if the stock price rises above $112. For example, if the stock price goes up to $115, Eric's profit will be $300; if it rises to $120, the profit will be $800.

We can have an even clearer picture if we use a profit/loss chart.

First, let's draw a horizontal axis representing the underlying price, starting from zero.

Then, draw a vertical axis representing the corresponding profit or loss on a share-for-share basis, with values below zero indicating a loss and values above zero a profit.

Still, let's look at the previous example. We can mark the strategy's break-even point, which is the strike price plus the premium, at $112 on the chart.

When the underlying stock price is below the strike price of $110, the loss is fixed at $200.

As the underlying price increases above $110, the profit/loss line is a 45-degree upward straight line, indicating that the increase in the underlying price results in an equivalent increase in profit/loss.

By visualizing different scenarios on the chart, we can understand the profit and loss potential of a strategy at expiration better.

Similarly, we can make a profit/loss chart for a short call, a long put, and a short put.

With all the other elements being the same, the profit/loss charts for a long call and a short call are symmetrical, with the horizontal axis as the axis of symmetry.

Likewise, the profit/loss charts for a long put and a short put are symmetrical, too.

You may wonder how to use profit/loss charts of options strategies.

They allow us to understand each strategy's theoretical profit and loss ranges and at what price it earns, loses, and breaks even, helping us better understand the upside and downside of different strategies.

Let's start with the basics and look at the comparison of a long call with a long put.

Both have limited loss potential theoretically and relatively large ranges of potential profits.

However, the potential theoretical profit of the long call strategy is unlimited. In contrast, the long put strategy has a limited potential profit because the stock price cannot fall below zero.

How about a short call and a short put, then?

Both have limited potential profits theoretically and relatively large ranges of possible losses.

However, the short call strategy has unlimited loss potential, while the short put strategy has a limited, but substantial loss potential.

Hopefully, you can know the profit/loss charts of the four basic strategies like the back of your hand because they are the foundation for more advanced strategies.

In that case, it may be easier to picture any strategy's P/L chart.

For instance, plotting the profit/loss charts of a long call and a long put with the same strike price on a chart, we may get a combined chart looking like a "V". This new chart shows the profit and loss potential of a multi-leg strategy known as a long straddle.

Combining the profit/loss charts of a long call strategy and a short call, we may get a chart looking similar to a "Z". This is the profit/loss profile of a call spread.

Understanding and remembering a strategy's P/L chart may help you make quicker and more informed decisions when trading options.

One more thing to keep in mind.

You may have noticed that all the charts mentioned above are charts at expiration.

In reality, though, the prices of options are subject to change all the time, leading to changes in the P/L charts, not always identical to the chart at expiration.

Traders may close their option position or exercise their option earlier.

For instance, if an American-style option, which can be exercised earlier than expiration, increases in value sharply, its holders may choose to close the position rather than hold it until expiration and exercise it.

Also, we must pay attention to the factors that may impact an option's price to make better decisions.

Some handy tools on moomoo may come to help in our decision-making, such as the Option Price Calculator and the Probability of Exercise.

That's all about P/L charts of option strategies. Do you have any thoughts? Please share them with us in the Comments.