Risk Curves
A Risk Curve, or payoff diagram as they are sometimes referred to, is a graphic representation of the profit or loss of a position in relation to price changes in the underlying security. When drawn with software, risk profiles can also take into account the effects of changes in time and volatility of the position. Risk profiles enable traders to visually assess a trade’s profitability in one glance.
The risk profile shown in Figure 12 is an example of a long call option that has been computer generated by HUBB Software, an options trading and analysis software program. The horizontal numbers at the bottom of the graph read from left to right showing the underlying securities price. The vertical numbers on the right show profit and loss in dollars. The sloping graph line indicates the theoretical profit and loss of the position at various times, including expiry, as it corresponds to the price of the underlying security.
In this risk profile example, we have purchased a call option with a strike price of $28.00 at a premium of 6.70 cents or $670 for one contract. (1 contract controls 100 shares). The max risk is equal to the call premium paid, in this case $670. The maximum reward is unlimited similar to owning the underlying stock.
You don’t need a computer program to calculate the basics of a risk profile; they can be drawn by hand for most option strategies at expiry (the solid line). However, if you want to go that next step and calculate what an options position will be worth at anytime prior to expiry (the dashed lines) or what it will be worth given a change in volatility, then you will need a software tool to calculate and draw it.
