Trading options may seem complicated, but there are tools available that can simply the task enormously. For example, calculating what the fair value of any option should be requires fairly complex mathematics, but a computer and the right software will take care of most of that work nowadays. But to trade options successfully, investors must have a thorough understanding of the potential profit and risk for any trade they are considering.

For this the main tool that option traders use is called a risk graph. Risk graphs allow you to instantly see your maximum profit potential, as well as the areas of greatest risk, by looking at a single picture. That makes the ability to read and understand risk graphs a critical skill for anyone that wants to trade options. With the stock price at: Your profit loss will be: This is easy to show on a two-dimensional graph.

The horizontal axis the x-axis should be labeled with various stock prices in ascending order. The vertical axis the y-axis is labeled with the possible profit and loss figures for this position.

That produces the following two-dimensional picture:. The advantage of risk graphs is that they allow you to quickly grasp a lot of information by looking at a simple picture. The picture also gives you an immediate understanding of both the risk and possible reward. You can see that as the stock price moves down, your losses get larger and larger, at least down to the point where the stock price hits zero and you lose all your money.

On the upside, you can see that as the stock price goes up your profit will continue to increase, with a theoretically unlimited profit potential. Creating a risk graph for option trades uses all the same principles we just covered. You simply need to calculate what the profit or loss is at each price of the underlying stock, place the appropriate point in the graph, and then draw a line to connect the dots.

Unfortunately, when analyzing options it is only that simple on expiration day. If you are considering an option position on the day the option s expire, you can just compare the strike price of the option s to the stock price to see what your profit or loss will be.

But at any other time between now and expiration day, there are factors other than the price of the stock that can have a big effect on the value of an option. One crucial factor is time. But an option is a wasting asset.

For every day that passes, all else being equal, an option is worth a little less. That means time is a critical element when evaluating the probable profit or loss of an option, and it makes the risk graph for any option position that much more complex. In order to display an option position on a two-dimensional graph there will normally be several different lines shown, with each line representing the performance of your position at different projected dates.

The call option allows you to control the same shares for substantially less than it cost to purchase the stock outright. Notice that there are three different lines, with the line legend on the right showing you how many days out each line represents.

Notice the effect that time has on this position. As time passes the value of the option slowly decays. Notice also that this effect is not linear. When there is still plenty of time until expiration, only a little bit is lost each day due to the effect of time decay.

As you get closer to expiration, this effect begins to accelerate. When you first purchase the option, you start out even at the zero line with neither a profit nor a loss. By having multiple lines that represent different dates in the future you are able to see this effect graphically. We mentioned earlier that calculating the probable profit or loss for options is easy only at expiration, when the only variable you need to calculate the value of an option is the stock price.

For any other day between now and expiration we can only project a probable, or theoretical price, for an option based on the combined factors of stock price, volatility, and time to expiration. We then compare the cost basis on the option to that theoretical price to determine the probable profit or loss. The fact that the profit or loss displayed in the risk graph of any option position is based on theoretical prices, and thus dependent on the inputs being used, should always be kept firmly in mind.

Many traders, particularly those just beginning to trade options, tend to focus almost exclusively on the price of the underlying stock and the time left in an option when assessing the risk of an option trade. But changes in volatility also have a large effect on the value of an option.

Anyone that is trading options should always be aware of the current volatility situation before entering any trade. To gauge whether an option is currently cheap or expensive, option traders look at its current implied volatility relative to both historical readings and their expectations for implied volatility in the future. When we demonstrated how to display the effect of time in the previous example, it was assumed that the current level of implied volatility would persist without any change into the future.

While this may be a reasonable assumption for some stocks, ignoring the possibility that volatility levels may change can cause you to seriously underestimate the risk involved in a potential trade. But how can you add a fourth dimension to a two-dimensional graph? Naturally there are ways to create more complex graphs with three or more axes. But two-dimensional graphs have many advantages, not least of which is that it they are easy to remember and visualize later.

So the preferred solution is to stick with the traditional two-dimensional graph. There are actually two possible ways to handle this problem. The easiest way is to simply input a single number for what you expect volatility to be in the future, and then look at what would happen to the position if that change in implied volatility does occur. This solution gives you more flexibility, but also has some serious drawbacks. The biggest problem inherent in this method is that you need to choose what number to input for future volatility.

The resulting graph would only be as accurate as your guess for future volatility. If implied volatility turns out to be quite different than your initial guess, the projected profit or loss for the position would also be off substantially. The other drawback to this method is that volatility is still held at a constant level. It would be better to be able to see how incremental changes in volatility would affect the position.

To do this we use the same trick we used before — keeping one of the variables constant, in this case time rather than volatility. We have used simple strategies to illustrate how to use risk graphs so far, but now we will get more complicated and look at a long straddle position. A long straddle involves buying both a call and a put in the same stock, with the same strike, and in the same expiration month.

This option strategy also has the advantage, at least for our purpose here, of being very sensitive to changes in volatility. This is a picture of what the trade will look like exactly days from now on September 11, , halfway between today and the January 17, expiration day. Each line shows the trade at a different level of implied volatility, with an increment of 2. Each additional line shows the trade at progressively higher levels of volatility, in increments of 2.

The line legend on the right indicates the exact increase each line represents. The advantage to this method is that it allows you to see how changes in implied volatility will affect this position. As volatility increases, so does your profit or at least your loss is smaller, depending what the price of the stock is. The converse of this is also true. Any decrease in implied volatility would hurt this position and reduce your possible profit.

This is a perfect illustration of why option traders need to understand how changes from the current level of volatility can affect the performance of a trade. As you gain experience and get a better feel for how option behave, it will also become easier to extrapolate in your mind what this risk graph would look like before and after this particular date. It is unlikely you would be able to predict off the top of your head what an option trade is likely to do.

Visualizing how the trade is affected by changes in time and volatility is even harder. That's what the risk graphs are for. They let you reduce the probable behavior of any option position, no matter how complex, to a single picture that is easy to remember.

Later, even if a picture of the graph is not right in front of you, just seeing a current quote for the underlying stock will allow you to have a good idea of how a trade is doing. Options involve risk and are not suitable for all investors. The information on this website is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current.

No statement within the website should be construed as a recommendation to buy or sell a security or to provide investment advice. The inclusion of advertisements on the website should not be construed as an endorsement or an indication of the value of any product, service, or website. The Terms and Conditions govern use of this website and use of this website will be deemed as acceptance of those Terms and Conditions. The material contained herein has been licensed by DiscoverOptions.

All copyrights regarding this content remain with the licensor. Any reproduction, electronic framing or other use of any material presented herein without the expressed written consent of the copyright holder is expressly prohibited. See the Courses Available at DiscoverOptions. Our Mission, Personnel and Contact Information.

Get a Day Trial Here! FREE articles on trading, options, technical analysis just a click away!

More...