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Chapter 1. Introduction to Options > Risk Profile Charts

Risk Profile Charts

Do you know what buying an asset such as a stock or a future looks like? To find out, we need to learn how to draw a Risk Profile Chart. This is the cornerstone on which we build far more complex strategies, so it’s important to understand this right now.

Example 1.1.

Consider a stock XYZ Inc. You buy the stock for $25.

  1. The X-axis is the stock price, with the price rising as the line moves right.

  2. The Y-axis is your profit for the trade.

  3. The 45° diagonal line is your risk profile for the trade. As the price of the stock (or underlying asset) rises, so does your profit in this example. So when the asset price rises to $50, you make $25 of profit:

    Current priceBuy price=Profit (loss)

Chart 1.1. Buying an asset risk profile.

Steps to Creating a Risk Profile Chart

Step 1. Y-axis for profit/loss position

Step 2. X-axis for underlying asset price range

Step 3. Breakeven line

Step 4. Risk profile line

Now that you know what buying an asset looks like, we can move straight onto what shorting an asset looks like. Shorting simply means selling something that you don’t already own. Shorting is an accepted concept in some stock markets such as the USA, but is not currently allowed in some other stock markets such as the UK.

Remember that when you short you can lose an unlimited amount as the asset price rises, and your maximum profit is the shorted price. To make maximum profit from a short stock position, the asset would have to fall to zero.

Chart 1.2. Shorting an asset risk profile.

So now that you know how to draw the most basic risk charts, let’s talk about options. . .

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