How to read a payoff diagram
A payoff diagram is the single most useful picture in options. It plots your profit or loss at expiration (vertical axis) against the price of the underlying (horizontal axis). Learn to read one and you can size up any strategy at a glance — where it makes money, where it loses, and how much of each.
The anatomy
Three features tell you almost everything: the breakeven (where the line crosses zero — the price at which you neither make nor lose), the kinks (each bend sits exactly at a strike price, where the payoff changes slope), and the flat sections (where profit or loss is capped). An arrow at either end means the line keeps going — unlimited profit or loss in that direction.
The four basic positions
Here are the four building blocks from earlier, drawn on a $100 stock with a $100 strike and a $5 premium. Notice the mirror symmetry: the long and short versions are reflections across the zero line.
Reading them
The two long positions have a floor: the most you can lose is the premium, so the line flattens at −5 and the arrow points to open-ended profit. The two short positions are their mirrors: profit is capped at the premium collected (the line flattens at +5) while the loss arrow runs open-ended against you. In every case the bend is at the $100 strike and the breakeven is the strike offset by the premium.
Ask “what happens to a long call if the stock is at $103 at expiration?” The diagram answers instantly: $103 is above the $100 strike but below the $105 breakeven, so the option is worth $3 of intrinsic value against the $5 paid — a $2 loss. You didn’t need a formula; you read it off the line. Multi-leg strategies, where four legs interact, are where payoff diagrams become indispensable.
Common pitfalls
Confusing the strike with the breakeven. They’re different: the kink is at the strike, but you don’t start profiting until the premium is recovered, which is the breakeven.
Forgetting the diagram is “at expiration.” Before expiration, extrinsic value rounds off the kinks. The sharp corners appear only on the last day.
What to do with this
For any strategy you consider, sketch or pull up its payoff diagram first. Find the breakevens, the max profit, and the max loss before you trade — the whole risk picture is in the shape. Every strategy lesson in this library includes one. The final foundation: what actually moves these premiums day to day.
Next lesson · continue the courseWhat drives an option’s price →
Every strategy in the library ships with its own payoff diagram. Start with the covered call.