A payoff diagram is a graph that shows the potential profit or loss of an options strategy at different prices of the underlying asset at expiration.
Mechanics of the graph
Traders use these diagrams to map out the financial outcome of an options trade before executing it. The horizontal axis represents the price of the underlying asset, such as a stock or commodity, at the exact date the option expires. The vertical axis measures the resulting financial gain or loss from the position. When the line plotted on the graph is above the horizontal axis, the trade is profitable. When the line falls below the horizontal axis, the position is operating at a loss.
The point where the plotted line intersects the horizontal axis is the breakeven point. This specific spot indicates the asset price at which the trader neither makes money nor loses money, factoring in the initial premium paid for the options contract. Traders look at the steepness and direction of the lines extending from this point to understand their exposure to market movements.
Different options strategies create distinct geometric shapes on the chart. A simple long call option produces a line that stays flat below zero until the strike price is reached, at which point it slopes upward diagonally. More advanced combinations, such as iron condors or straddles, combine multiple flat and diagonal sections to illustrate capped profits and limited losses across a specific range of asset prices.
Example
Suppose you are an Elephant looking to hedge the rising costs of your daily diet by purchasing a call option on an agricultural firm, Savannah Harvest. You buy a call option with a strike price of 50 units of currency, paying a premium of 5 units.
If you draw the payoff diagram for this trade, the horizontal axis shows the potential share price of Savannah Harvest at expiration, and the vertical axis tracks your profit or loss. For any stock price between 0 and 50 units, the plotted line remains flat at a negative 5 on the vertical axis. This flat line represents your maximum loss, which is the premium you paid.
At a stock price of 50 units, the line begins sloping upward at a 45-degree angle. It crosses the horizontal zero line at 55 units, which is your breakeven point – the 50 unit strike price plus the 5 unit premium. If Savannah Harvest shares rise to 70 units due to a poor harvest season driving up crop values, the line on your graph continues upward to show a net profit of 15 units.