Option Trading Tutorial Part 3: Payoff Functions Continued: Options, Futures, Derivatives & Commodity Trading

# Option Trading Tutorial Part 3: Payoff Functions Continued

Continuing further from the 2nd part Options Payoff Functions, here is the 3rd part of the series on option trading tutorials.
However, nothing in this world comes for free. So let’s introduce a practical price in the above case. Suppose the price increases from in the following sequence 50, 51, 52 & 49 from 7th September to 10th September respectively. We will have the following situation:

 Buy Price 50 Date Stock Price Profit/Loss 07-Sep-07 50 0 08-Sep-07 51 1 09-Sep-07 52 2 10-Sep-07 49 -1

Proceeding in a similar way as above, let’s plot the graph for the above table. WE will have the following: As we can observe, the profit and loss values are plotted (on the vertical axis), for the corresponding movements in the stock prices (on the horizontal axis). So, using the above graph, we can tell how much profit/loss our investment is making, when the stock price is at so and so level. For e.g., if the stock price is at 51, then we make a profit of 1 dollar. If the stock price is at 49, then we make a loss of 1 dollar (-1 value on vertical axis).

Hence, using these graphs, it becomes easy for us to understand the profit and loss values for the corresponding movements in the stock prices.

It looks very very simple. Any novice will know that if he had bought a stock or any other thing at X dollars, then the profit/loss will be calculated based upon the difference between the current market price and the buy price of X dollars. So what’s the big deal in explaining this entire thing through a graph?

The main thing to notice here is that these graphs form the basis of derivatives tutorials. They are very important for understanding derivatives, because without these graphs it is not possible for anyone to understand derivatives. You may have seen lots of options trading website on the internet – but were you able to understand options correctly till now? If yes, then it means you really know derivatives, so no point in reading through this tutorial. If not, then you should understand these graphs and their working.

Whether you are a novice or experienced finance person, you are requested to understand these graphs clearly. In financial world, these functional graphs showing profit/loss with respect to the stock price movements are called the pay-off functions.
Let's head over to the next part Payoff Functions Continued

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