In Part One, we covered some of the basics on options, including what they are and what goes into option values. In this article, we will be covering simple payoff profiles and how you can use them to trade options.
Read Also: Finance Dummies Series: Options (Part One)
What Are Option Payoff Profiles?
Since options are nothing more than contracts, their values depend on various “if-then” scenarios.
There are mainly two types of options: calls and puts.
Call option
A call option is considered to be trading “in-the-money” (ITM) when the underlying stock price is trading above the option’s strike price. It is “out-of-the-money” (OTM) when the stock is trading below the strike price.
How much will you actually make and how much risk you are exposed to, upon the expiration of the option? Simply, the last day the holder of the option may exercise it according to its terms.
Payoff profiles will help you understand these.
Payoff Profile Of A Call Option
Consider the following: You bought a call option at a price of $1, with a strike price of $10. The above diagram shows the earnings of the option for various price levels of the underlying stock (left axis). The right axis showcases the stock prices on the date of expiry that correspond to various payoffs on the left.
Hence, if the stock were trading at $14 on expiry, your profit would be $3.
The diagram also easily showcases your loss should the stock trade below $10 by expiry. You can clearly see that your maximum loss will only be the cost of the option ($1), even if the stock went to $0 in price. Thus, by looking at the payoff diagram, one can tell that this trade has a good risk-to-reward profile, where your losses are capped at a certain amount while the reward can be unlimited.
Lastly, you have to take note of the breakeven (B/E) point, where the stock has to trade above for one to make a profit. If the stock trades above $10 but below the breakeven point of $11, one will still lose money.
Payoff Profiles Can Also Be Applied To Stocks
Let us now look at the payoff profile of owning stocks versus call options. Although there are significant differences (for e.g. Investment time horizon etc.), the simple differences between their payoffs can be easily summarized by the above diagrams.
With stocks, your maximum loss is not limited and you can even risk losing everything you invested should the price goes all the way to $0. However, if you are right and the stock goes up, you will have the same upside as the option.
Hence, the risk-to-reward profile of owning a stock is actually worse than that of an option, where stocks have more risk but the same reward compared to options.
Read Also: The Hard Truth About Income-Generating Options Strategies
Top Image Credit: DollarsAndSense.sg
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