Option Payoff Diagrams explained -With examples from stock option trading strategy
A put is in the money when the price of the underlying is below the strike and out of the money when the underlying trades above the strike price. If GM trades at $37 the option will be exercised with a profit of $2 and with GM at $39 the profit will be $4. If we put these points into our pay-off diagram and connect the dots we get the diagram below.
This is the very characteristic hockey-stick profile of a call option. The 45 degree part of the line shows the one-to-one relationship between the option value and the price of the underlying stock at delivery. Below the strike changes in the price of the underlying has no effect on the value of the option. The kink at the strike price when the option goes from OTM to ITM is what makes options fundamentally different from stocks and futures. The pay-off profile is non-linear as opposed to stocks and futures which are linear instruments. This kink makes it possible to tailor make pay-off profiles. You can create a vast number of different pay-off profiles with options. Something that is impossible with stocks and futures. No matter how you combine stocks and futures you will always end up with a pay-off profile that is a straight line. This makes learning option trading strategy very interesting.