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I was reading about different option strategies at TradeKing and although I think I understand how these strategies work, I don't see how they are explained by the accompanied graphs.

So just to take two examples...

We have the basic "Short Put" strategy that has a graph like this:

option strategy: short put

This strategy obligates the seller of the option ("put") contract to buy the stock at strike price A if the option is exercised and assigned. The TradeKing page says:

This strategy has a low profit potential if the stock remains above strike A at expiration, but substantial potential risk if the stock goes down.

Then there is the "Short Put Spread" strategy that has a graph like this:

option strategy: short put spread

This strategy does two things:

  1. obligates the seller of the option contract to buy the stock at strike price B, if the option is exercised and assigned, and
  2. gives the seller of the option contract the right to sell stock at strike price A

The questions I have about these two graphs:

  1. What do the blue lines represent?
  2. It looks like the outcome from these strategies is more on the side of "loss" until the point where the blue line crosses the horizontal "Stock Price at Exp." line. Wouldn't it be more correct for the entire blue line be above the horizontal line (on the side of the profit) until point "A"?

(Admittedly I am probably misunderstanding something here)

  • The blue line represents your profit/loss at various values of the stock price. – Victor Dec 7 '16 at 7:56
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The blue line is illustrating the net profit or loss the investor will realise according to how the price of the underlying asset settles at expiry.

The x-axis represents the underlying asset price. The y-axis represents the profit or loss.

In the first case, the investor has a "naked put write" position, having sold a put option. The strike price of the put is marked as "A" on the x-axis. The maximum profit possible is equal to the total premium received when the option contract was sold. This is represented by that portion of the blue line that is horizontal and extending from the point above that point marked "A" on the x-axis. This corresponds to the case that the price of the underlying asset settles at or above the strike price on the day of expiry. If the underlying asset settles at a price less than the strike price on the day of expiry, then the option with be "in the money". Therefore the net settlement value will move from a profit to a loss, depending on how far in the money the option is upon expiry. This is represented by the diagonal line moving from above the "A" point on the x-axis and moving from a profit to a loss on the y-axis. The diagonal line crosses the x-axis at the point where the underlying asset price is equal to "A" minus the original premium rate at which the option was written - i.e., net profit = zero.

In the second case, the investor has sold a put option with a strike price of "B" and purchase a put option with a strike price "A", where A is less than B. Here, the reasoning is similar to the first example, however since a put option has been purchase this will limit the potential losses should the underlying asset move down strongly in value. The horizontal line above the x-axis marks the maximum profit while the horizontal line below the x-axis marks the maximum loss. Note that the horizontal line above the x-axis is closer to the x-axis that is the horizontal line below the x-axis. This is because the maximum profit is equal to the premium received for selling the put option minus the premium payed for buying the put option at a lower strike price. Losses are limited since any loss in excess of the strike price "A" plus the premium payed for the put purchased at a strike price of "A" is covered by the profit made on the purchased put option at a strike price of "A".

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