It is important to compare the risk graphs of stock versus those of options in order to comprehend the different risks associated with the two.
In this example, the investor is purchasing stock at $35 per share.
When an investor purchases a stock the risk graph looks like the picture below. The slanted red line represents the profit and loss levels based on the movement of the stock price. For example, at $35 per share there is no profit or loss. If the stock price were to move up to $50 per share, the profit would be $15 per share. Conversely, if the stock were to move down to $25 per share, the loss would be -$10.
In the next example, the investor is shorting the same stock at $35 per share.
When an investor shorts a stock the risk graph looks like the picture below. The slanted red line represents the profit and loss levels based on the movement of the stock price. For example, at $35 per share there is no profit or loss. If the stock price were to move down to $20 per share, the profit would be $15 per share. Conversely, if the stock were to move up to $45 per share, the loss would be -$10.
Risk graphs are very straightforward. One key point to consider is the amount of capital that is at risk. As is the case with all stocks, a lot of capital allocation is required to create gains. Also, shorting a stock has unlimited risk as the price could theoretically never stop going up. Purchasing stock also has large risk associated with it because the stock could go to zero.
This is where equity options are far superior in comparison to stocks. As the next lesson will show, options allow investors to risk less while potentially generating much larger percentage returns.
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