Why the picture comes first
An option position has a shape. Whatever the underlying does between now and expiry, the outcome at expiry is a fixed function of one number — where the underlying finishes. That function can be drawn, and once it is drawn there is nothing left to argue about.
Most option losses that feel like surprises were not surprises. They were visible in the diagram before the trade was placed, and nobody drew it.
A spread, drawn
Below is a bull call spread: buy a call at a lower strike, sell one at a higher strike, same expiry. The numbers are invented; the shape is the point.
Notice what the flat sections mean. Below the lower strike, it does not matter how far the underlying falls — the loss is the same. Above the upper strike, it does not matter how far it rises — the gain is the same. You have sold away the tail in both directions, deliberately.
Every option structure is a trade between how much you can lose, how much you can make, and how often you are right. The diagram is where you see the price of that trade.
How to read any payoff
Four questions, in this order, on any diagram you are shown:
- Where is the flat part on the left? That is your maximum loss. If there is no flat part on the left, your loss is not capped.
- Where is the flat part on the right? That is your maximum gain, if it is capped at all.
- Where does the line cross zero? That is breakeven — the level the underlying must reach for the position to have been worth taking.
- How far away is that from where the underlying is now? This is the question people skip, and it is the one that decides whether the structure is sensible.
Here is the same structure with the strikes further apart and a larger premium paid. The shape is identical; the trade is not.
Comparing two structures by their maximum gain alone. Maximum gain is the least reliable number on the diagram because it is also the least likely outcome. Compare breakevens and maximum losses first; they are the parts you will actually meet.
Read it yourself
Use the first diagram above and answer without scrolling back to the caption.
- If the underlying finishes at 195, what is the outcome?
- If it finishes at 260, what is the outcome?
- What must it reach for the position to break even, and how was that number arrived at?
Show answers
1. A loss of 12 — the net premium. Below the lower strike the line is flat, so 195 and 150 produce the same result.
2. A gain of 28. Above the upper strike the line is flat too: the spread between strikes is 40, less the 12 paid.
3. 212 — the lower strike plus the net premium. Everything below that is a loss, however small.
Terms used
- Payoff
- The result of a position at expiry, as a function of where the underlying finishes.
- Strike
- The price written into the contract, at which it can be exercised.
- Net premium
- What was paid less what was received, across all legs of the position.
- Breakeven
- The level at which the position returns exactly nothing.
- Capped
- Bounded — a flat section on the diagram, beyond which the outcome stops changing.