Options Pricing: Profit and Loss Diagrams

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This is part 5 of the Option Payoff Excel Tutorialwhich will demonstrate how to draw an option strategy payoff diagram in Excel. One decision we need to make is the range of underlying prices that our diagram will cover. We will make the underlying price range easy to change by setting up two cells for user input — chart start in cell I5 and chart increment in cell I6, as the screenshot below shows.

The formula in cell B13 is:. This will enable us to copy the formula from option payoff diagram tool B13 to the cells below it. Each subsequent row will show underlying price higher than the previous one, with the increment set in cell I6. Copy cell B13 to 48 following rows — cells B14 to B Then test your formulas by changing the chart settings in cells I5-I6 and make sure column B is showing the underlying prices that you expect.

For example, this is chart start set to 10 and increment set to 2. Now we have X-axis ready and can calculate the payoff at each point. Of course, the formulas in all rows will be the same — we will create them in the first row row 12 and then copy them to the other rows.

We can use the formulas which we already have in rows 8 and 9, but will have to make a few adjustments. Now we can copy the formula that we have created in cell C12 to all other cells in the CF61 range.

Now we can just create a standard line chart with values range Option payoff diagram tool and labels range BB It option payoff diagram tool show the payoff diagram for our strategy. We can control the underlying price range effectively zoom in or out by changing the chart settings in cells I5-I6.

We can also display payoff diagrams for individual legs — in such case the chart series value range will be CC61, DD61 etc. There is of course plenty of room for improvement in terms of layout and visual design — you can change the colors or locations of different parts to adjust the spreadsheet option payoff diagram tool your option payoff diagram tool, you can make the chart bigger and more prominent etc.

In next two parts of the tutorial, we will look at the calculation of maximum profit, maximum loss and risk-reward ratio. Go to next part: If you don't agree with any part of this Agreement, please leave the website now. All information is for educational purposes only and may be inaccurate, incomplete, outdated or plain wrong. Macroption is not liable for any damages resulting from using the content. No financial, investment or trading advice is given at any time. Home Calculators Tutorials About Contact.

Tutorial 1 Tutorial 2 Tutorial 3 Tutorial 4. Drawing Option Payoff Diagrams in Excel. Underlying Price Range One decision we need to make is the range of underlying prices that our diagram will cover. The option payoff diagram tool in cell B13 is: Notice the dollar sign absolute reference before the B, but no dollar sign relative reference before the When we copy the formula to other cells, this will make the option payoff diagram tool in the other columns C, D, E still point to column B, but each row option payoff diagram tool use its own underlying price input.

For similar option payoff diagram tool, we must adjust the references to cells C3, C4, C5 and place dollar signs this time before the row number, but not before the column letter. It is just like the end of the formula in cell C9, but this time without the ABS, because we also need the direction.

Make sure you get the dollar signs right. Next Steps There is of course plenty of room for improvement in terms of layout and visual design — you can change the colors or locations of different parts to adjust the spreadsheet to your preferences, you can make the chart bigger and more prominent etc.

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This series of articles has covered the use of the Option Payoff Graph as a trade analysis tool for option trades. This final article in this series will examine how the option payoff graph depicts possible changes in market expectations, otherwise known as Implied Volatility. I should say here that the bullish case for GE did not look nearly as strong on February 10 as it had when we first suggested it on January But the stock did not take the kind of bounce that we were hoping for.

This is not surprising since the general market direction has been very bearish. They had 36 days until expiration. They demonstrate how we can visualize the profit picture at different dates in the future, at any price for the stock. The red line is how things looked on Feb 10, with 36 days to go.

The green line is how they would look 12 days later, the blue line 12 days after that and the gray line as of the expiration date on March All of those lines were drawn assuming that the expectations of volatility for the stock remained unchanged. This is the default assumption. But we also would like to know how things would be affected by a change in expectations. How much more would they be charging us to buy those options back in that case?

How much cheaper would those options be? The payoff graph can help us with this part of the trade analysis as well. By working those changes in assumptions into the payoff graph, we can see the subtle differences in the projected outcome. Compare the payoff graphs below to the first one:. Notice above that all of the curved lines are higher at every stock price — a reduction in volatility after we have sold puts and pocketed the money increases our profit. Here, on the other hand, we see how an increase in volatility would reduce our profits at any date and stock price.

That is because if volatility increased, the price we might have to pay to buy the option back and terminate the trade would increase, reducing our profit.

If we had a strong expectation that the level of implied volatility would either rise because it was abnormally low or fall because it was abnormally high , then being able to model those expected changes would allow us to quantify the effect. For option traders, the effort spent learning to use this invaluable trade analysis tool is well worth it.

Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein.

Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.