The important things to notice on the two long side diagrams (purchasing an option)
Your loss is basically your purchase price mitigated by any gains from executing the option above water. So in the example below, any option not exercised costs you $2 and with no corresponding gain creates a $2 per option loss. In each case though, when the option becomes executable (the stock price is above the call price or below the put price) the loss becomes lower as contra profits are brought in and eventually the profits become positive. The profit on a long call is unlimited (as the stock price can rise to any level) and the profit on a long put is only limited by the distance between the current stock price and $0.
The important things to notice on the two short side diagrams (selling an option)
You will notice first that the graphs are basically inverted copies of their counterparts above. This is because the profit from a short position comes from the proceeds of the option sale and the option condition not happening. You will notice that the profits from the option become smaller as the option becomes executable. Ultimately profits turn into opposite losses after the share price has moved above the call price or below the put price by an amount in excess of the option price. You will notice that your call losses in this case are unlimited (as the option can continue to rise indefinitely) and your put losses are limited only by the security acquiring a $0 value.
Once you have a handle of the option payoff diagrams for plain vanilla options you can build option stradels.
Categories:
Finance_Principals,
How_To_Trade,
Introduction,
Options