Option Payoff Diagrams explained -With examples from stock option trading strategy
On this page you'll learn how to visualize a stock option trading strategy by drawing pay-off diagrams.
A pay-off diagram is a graph that shows the value of the option position compared to the price of the underlying. It’s important to learn that a basic pay-off diagram pictures the value of the option trading strategy position on the day of expiry. Before we get into drawing pay-off diagrams I will illustrate this point with a short example.
Imagine that you have a call option for GM stocks with a strike price of $35 and GM stocks are trading at $35. If this is the case on the expiry date, the call option will be worthless. If it’s before expiry there is always a chance that GM will move above the strike price and the option will be worth exercising. How much the option is worth before expiry date is something we will look closer at later. This example shows that on expiry date it’s very easy to know the exact value of a stock option trading strategy position but before expiry it’s trickier to put an exact number on the value. Therefore our first pay-off diagrams will picture the value of the stock option trading position at expiry. A pay-off diagram has the price of the underlying on the horizontal axis and the value of the stock option trading position on the vertical axis.
We’ll make a diagram for the GM call with a strike of $35. Clearly this call is worthless if the GM stock trades at or below $35 at expiry date. An option that has the same strike price as the price of the underlying is said to be “at the money” (ATM). When the price of the underlying is below the strike price, a call would have zero value if exercised and is said to be “out of the money” (OTM). When the price of the underlying is above the strike of a call, the call is said to be “in the money” (ITM).