Lessons › Advanced track › Option payoff diagrams

World 10 · Advanced track · lesson 4 · level 4

Option payoff diagrams

Option buyers can lose only what they paid, but option sellers can lose far more than they collect.

In one line

Four simple lines show how every basic option trade ends at expiry. Which one hides a cliff?

Explained simply

A payoff diagram is like a scoreboard that shows your result for every possible final price. For a call buyer, the line stays flat at a small loss and then climbs like a hockey stick. For the call seller it is the mirror image: a small win that can turn into a steep fall.

The lesson

A payoff diagram shows profit or loss at expiry across possible prices of the underlying. A call buyer's loss is capped at the premium and the position profits once price rises above the strike plus the premium, while a call seller keeps the premium but faces losses that are unlimited in theory. A put buyer profits below the strike minus the premium, while a put seller can lose up to the strike minus the premium if the underlying falls to zero. The breakeven is where the line crosses zero, so the premium must always be included.

A worked example

Illustrative example: a stock is at 100. A 100-strike call costs 4 and a 100-strike put costs 3. The call buyer breaks even at 100 + 4 = 104. If the stock ends at 112, the call buyer makes 112 - 100 - 4 = 8 per share, or 8 x 100 = 800 dollars per contract, and the call seller loses the same 8 per share. The put buyer breaks even at 100 - 3 = 97, and if the stock ends at 90 the put buyer makes 100 - 90 - 3 = 7 per share. If the stock fell all the way to 0, the put seller would lose 100 - 0 - 3 = 97 per share.

The same idea at four levels

1. Beginner. A payoff diagram shows your profit or loss at expiry for every possible final price.
2. Foundation. When you buy a call or a put, your loss is capped at the premium you paid.
3. Intermediate. Breakeven is the strike plus the premium for a call buyer, and the strike minus the premium for a put buyer.
4. Advanced. Sellers mirror buyers: a call seller's loss grows without limit as price rises and a put seller can lose up to the strike minus the premium, so selling options for 'steady income' carries a big hidden risk.
5. Expert. A long call gives similar upside to owning shares above breakeven with a capped loss, but you pay for that cap with the premium, which is lost if the move is too small or does not come before expiry.

Mistakes to avoid

• Selling options for 'steady income' without understanding the size of the possible loss.
• Leaving the premium out when working out the breakeven price.
• Reading a payoff diagram as a prediction instead of a map of possible endings.

Goal of this lesson: Read payoff diagrams for buying and selling calls and puts, and compare their risks.