One of the most important and advantageous features of trading options is the measurable control of risk. Unlike stocks and ETF’s which have obscure and often times unlimited risk potential to the money in your account, options have spreads and strategies that give you a measurable and controllable amount of risk. However, in order to make the most of this, you have to understand how to use a risk graph.

A risk graph is a simple graph that illustrates what happens to an options trade based on the value of the underlying asset. It’s drawn out on an XY axis where the X axis represents price of the underlying and the Y axis represents how much money you make, or lose, should the underlying reach that price. When you look at a risk graph, you are essentially looking at every possible outcome of an options trade and what it will do to you financially, which is an invaluable asset to any options trader.

Typically on any options trade illustrated on a risk graph you have two lines, one hard and another smooth and curved. The hard line represents the options value at the time of expiration. This means how much money you stand to make or lose should the option expire and either need to be bought back to cover your position or be exercised. This is ideally the point that every successful options trader wants to reach on the risk graph. Assuming you played your trade well, you will always realize maximum profit by waiting until expiration, illustrated by the hard line on your risk graph.

The smooth line illustrates the value of the option on the day of purchase. It’s curved because the day you purchase an option, you are purchasing a certain amount of time value, so the option doesn’t appreciate or depreciate in value as dramatically as it does after reaching expiration. The time value balances out any immediate growth or decline in the value of the underlying, so you are without a full profit if you turn around and immediately sell your option after it increases in value.

Here’s an example of a risk graph on a vertical options trade. The vertical is a very simple trade, and in this example we are doing a vertical credit spread on the SPY with our strike prices at 114 to sell and 115 to buy. Basically this spread is selling a call one strike out of the money and buying a call two strikes out of the money. The first call is for profit, the second is to control risk. You can see that as soon as the SPY reaches and exceeds 114 I immediately start losing money because I sold a call at 114. However, because I bought a call at 115, the losses are stopped out at $580. This is because the appreciation of the call I bought will cancel out the appreciation of the call I sold, making my position from 115 and above a neutral one capable of no further losses. Neat, huh?

If you are using a risk graph for an options trade, typically you will either have to gain the advantage of probability or the advantage of profit. In a trade where you are statistically more likely to win, you stand to lose more than you stand to gain should you turn out to be wrong, and vice versa. You can either have the odds or the capital in your favor on any trade, and looking at the options trade on a risk graph will help you measure it and control it.