Payoff Diagrams
The best way to understand option strategies is to look at a diagram of how they behave.
Let's look again at the basics of a Call Option. Here is an example;
Underlying: MSFT
Type: Call Option
Exercise Price: $25
Expiry Date: 25th May (60 days until expiration)
Let's imagine that this option is worth $1.2. This means that the shares have to be trading at $26.20 for us to break even (Exercise Price of $25 plus the Option Premium of $1.20). If the shares are trading anywhere above $26.20 then we can start counting the profits. Anywhere below $26.20 and we lose out by the premium - $1.20. So, with a long call we have limited risk (the Option Premium) while at the same time having unlimited profit potential. Let's look at a graph of this concept;
The horizontal line across the bottom (the x-axis) represents the underlying instrument - in this example, the share price of Microsoft. The vertical axis illustrates our profit/loss as the shares move up or down.
The blue line is our payoff.
You can see that the vertical distance between the 0 profit line and the blue line is our maximum loss, i.e. the amount we paid for the option. So, anywhere under our break even point of $26.20 means that the option isn't profitable and we will not exercise and we will lose any premium we paid. If the market crashes and the stock goes bankrupt, our maximum loss will still only be the premium we paid.
However, as the shares trade past the $26.20 mark we start making money. If, at expiry, Microsoft shares are trading at $50 then we will make $23.80 per share.
How? Because we will exercise our right and have the seller of the option hand over Microsoft shares at a value of $25 (the exercise price). Minus the amount we have already paid for the option and we have a profit per share of $23.80.
What about if we sell a call option?
If the shares trade anywhere below $25 then we keep the $1.20 that we received when we sold the call option - the option premium.
However, if the market rallies then our losses become unlimited.
For more option payoff charts, be sure to check out the option strategies link. Or, to see option strategies in action, take a look at the option tutorials section.
Comments (17)
Peter
June 9th, 2010 at 12:37am
Hi Dolf, the question Carter asks is in relation to a naked call, not a covered call - they have different payoff profiles. Sure, a covered call's losses is technically limited to the stock price going to zero. Not unlimited - but a lot.
With a covered call, you're short a call option. Once the stock trades below the strike the holder of the option won't exercise, so you just lose the premium and the option value goes to zero. However, you are still long stock, which will lose value as the price drops - not unlimited, sure, but all the way to zero.
As the stock rallies past the strike, yes, you would be called out and have to sell the stock at the strike price offsetting the long position already held in the stock making the profit realized the premium already received for selling it. This is why a coverved call is a bullish strategy as you want the market to rally so you are called away and give up the stock.
Dolfandave
June 8th, 2010 at 1:46pm
Peter, As Carter mentione (two years ago:) in the first post below there is some question to "unlimited" losses. Yes if this is a naked call. I have been studying covered calls in my trek to learn options trading and if it were a covered call I personally don't view it as an unlimited loss. If I buy an OTM option as I understand this is the best technique w/ covered calls, then I will make the premium paid to me for writing the call plus the difference between the purchase price of my stock and the strike price. I don't think this is a bad deal nor would I really cry about it if I got called out in this situation. I wouldn't necessarily buy back the same security if I got called out. Your thoughts?
joel
April 8th, 2010 at 1:54pm
thanks guys i was struggling to understand the pay offs now it has become easy
Peter
June 11th, 2009 at 12:03pm
Hi Henry,
Hard to say exactly, but the following article points to the CBOE saying 10% of options are actually exercised:
http://www.protraderdigest.com/articles/20081025_7
Mmm, I've never heard of this happening. If the option is very close to expiration and a company is bidding up the options above their intrinsic value, market makers would arb them out by selling the options and hedging with the stock.
henry
June 9th, 2009 at 9:10am
Hi, silly question im sure...
but what ratio (about) are options actually exercised and go through to trade? Im guessing people get it wrong more than right and therefore it is extremely common to not exercise the trade.
Secondly, are there companies out there that buy up your options once they have alot of intrinsic value very near to expiration and you dont have the liquidity/cash to exercise the trade (hence why you would sell it). I hope that makes sense. Thanks
Peter
May 21st, 2009 at 6:37am
Hi Rajeev,
Your clearer decides who the counterparty is if you decide exercise your option. The person on the other side will be a holder of a short call option.
About your second question...if you bought the option and then sold it 3 months later, you no longer have a position. You would only be obliged to sell shares if you were short the call option and the buyer exercised the option.
Rajeev
May 20th, 2009 at 9:52pm
This is very useful After going through the whole thing, I have a question. If I decide to exercise the call option, who is the other side, who is going to sell the stock. On the same thought, if I bought the call option for 1.20, sold it for 2.00 3 months later, at the time of maturity, if the buyer decides to exercise the right, am I supposed to provide the shares or the whoever wrote the call option originally.
Peter
May 5th, 2009 at 7:32pm
Hi Tom,
It depends on the specifications of the options, but generally, yes. In the US exchange traded options have a "multiplier" or "contract size" of 100, so the price is multiplied by 100. However, in Australia the multiplier is 1,000. So it depends on the exchange where the options are traded.
Tom
May 5th, 2009 at 10:59am
Sorry for the very basic question, but if you're buying an option priced at $1.20 as in the above example, are you physically paying $1.20, or is it multiplied by 100, i.e. $120?
Peter
April 13th, 2009 at 7:01am
Hi Chuck,
It depends on the exchange. For example, in the US there is no charge for exercise and assignment for US stock options, however, in Australia and Europe you will be charged commissions.
This was taken from the Interactive Brokers website under Fees and Commissions:
http://www.interactivebrokers.com/en/accounts/fees/commission.php
Chuck
April 11th, 2009 at 5:04pm
If you intend to exercise your in the money call option and sell the stock immediately to realize your profit, would you also incur two stock trade fees as well as the original option purchase fee ? Are option trading fees similar to stock trading fees ?
Peter
April 9th, 2009 at 7:42am
The last trading day for April 09 options in the US is Friday the 17th. CBOE shows the 18th (Saturday) as the expiration date but Yahoo! is currently showing 17th when checking MSFT options. I couldn't see the 11th mentioned. I would say that's what it comes down to..."technically" they expire on the Saturday following the third Friday of the expiration month. But really Friday is the last trading day...i.e. you cannot get out of the option by trading it on a Saturday.
Jack
April 8th, 2009 at 1:39pm
april contracts on scottrade expire on 4/18. april contracts on yahoo financial expire on 4/11. I don't understand.
Admin
October 9th, 2008 at 4:52am
Hi Queenie,
Sorry...don't fully understand your question.
You will know the Microsoft is trading at $50 because of the price in the open market.
Queenie
October 6th, 2008 at 7:44am
"If, at expiry, Microsoft shares are trading at $50 then we will make $23.80 per share."
How would you know the shares are trading at $50 and will will make &23.80 per share.
Admin
October 3rd, 2008 at 8:43pm
Hi Carter,
When you sell a call option you are obliged to sell stock to the option buyer if s/he decides to exercise. Once the stock trades upwards past the strike price the buyer will certainly exercise the option as it is now ?in-the-money?. At this point you are effectively short the stock at the strike price of $25. Your losses have no limit and will continue to increase as the stock rallies. For example, if the stock is trading at $40 at expiration, you will be exercised and have to sell stock at $25 and buy them back on the open market at $40 for a $15 loss per contract.
Make sense?
carter
October 3rd, 2008 at 6:57pm
Why would our options be unlimited if the market rallies in the last example? Wouldn't we only lose the price of the contract, as in the other scenario, if the stock doesn't go above $26.20?
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