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2.4 Profit Loss (PL) Diagrams

It is really essential to understand profit/loss (P/L) diagrams, because they are the key element in understanding where to make money, where to break even, and where and how far the loss zone extends. It is important to understand how they work because they can help you understand complex strategies and how to apply them to the underlying.

Figure 4 : P/L-Diagram (Long-Call)

Here you can see a basic P/L diagram, which can be applied to all strategies accordingly. On the Y-axis you see a straight line, where everything above 0 represents a profit and everything below 0 represents a loss. The X-axis represents the price of the underlying. The break even is the point at which the chart moves from a loss to a profit zone.

Ultimately, this means nothing more than a representation of where the price of the underlying stock must be on the expiration date for you to be profitable. That's basically what we're looking at. The bluish line represents the strategy. Different strategies of course have different charts, because they are profitable at different times, or contain a limitation of the potential loss or not. In the course of this book you will see many more such graphs. Just when I teach you the individual strategies, they play an overriding role.

The example above represents a call option. You start in a negative area because you have paid a certain premium. Remember, you can't lose more than this. You will also see the strike price, which is the price at which you bought the option. As soon as this is reached, the graph starts to rise and finally reaches the break even. Remember, this is always higher than your strike in a call, because you have to calculate strike + premium paid. As soon as this value is exceeded, you start to run into the profit zone.

Figure 5 : P/L-Diagram (Short-Call)

Let's look at another example. In this case it is a short call. As you can see, the potential profit is limited, but the risk is unlimited. Also note that this time the break even will play in your favor. To calculate this, you take again the strike price + premium taken. Only if this point is exceeded and the stock continues to rise, you begin to enter the loss zone. On the other hand, it is irrelevant how far the stock falls below your strike. You will never earn more than the premium earned, but you have unlimited risk "downwards".

Let's look at a more complex strategy - the Iron Condor.

Figure 6 : P/L-Diagram (Iron Condor)

In this case, we benefit if the share moves within a defined corridor. It is completely irrelevant whether it is at the upper or lower limit on expiration date. You will be allowed to keep the premium in any case. This is a great example of non-directional trading, as you don't have to have an opinion about the further course of the stock. To put it bluntly, you don't care whether it rises or falls as long as it stays within a certain fixed corridor. You also see the break even points and that you have a built-in loss limit. You can't lose more than the previously set amount. Yes, this is also possible with options.

But before this becomes too much for you, we will stop at this point. Strategies will be discussed later. The most important thing was to understand what P/L diagrams are made of and how to read them.

Remember:

P/L diagrams always consist of several components.

Profit/loss zone, strategy, strike price(s), break even(s).

They allow you to get a visual idea of the current strategy - "what happens at what point".