Payoff diagrams are simple graphs that make it possible to track the increases and decreases in unit price of different stock options over a period of time. The data included on a payoff diagram makes it possible to determine the amount of potential profit and loss associated with the options that are being tracked. This is accomplished by plotting that anticipated profit or loss against the price of the underlying security associated with the option.
The detail included on a payoff diagram is invaluable when it comes to managing the option position. When prepared properly, the investor begins with the option pricing itself, and the value of the underlying asset. At that point, various market scenarios that are considered highly likely are applied to the movement of the underlying security. This helps to create a projection of when the option can be reasonably expected to increase in value, when it will go through a period of more or less flat performance, and when there is danger of the option losing value.
It is important to remember that a payoff diagram is only as good as the data that is assembled for the graph. A failure to accurately account for the most likely movements in the market place with have a detrimental effect on the accuracy of the graph. At the same time, the payoff diagram should not be considered a finished work. As new and unforeseen factors begin to exert influence on the market in question, it is often a good idea to go back and integrate that new data into the progress of the diagram. This strategy can help to minimize the chances of an unexpected loss due to sudden shifts from events like natural disasters or political changes.
When prepared correctly, the payoff diagram makes it easy to determine when it would be wise to hold on to the option, and when it would be prudent to sell off any interest in the asset. One advantage of the diagram is that by projecting the performance of the option over the long term, it is possible to have an idea how long a downward movement will last, and what is likely to happen when the option price begins to move upward once again. Based on these projections, an investor may choose to hold on to the option during the downward trend, if the projected movement upward after the lull is highly likely to earn a significant return. This can help the investor avoid the mistake of selling off options too quickly, when in the long run those investments would earn a great deal of profit.