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.
Sorry...don't fully understand your question.
You will know the Microsoft is trading at $50 because of the price in the open market.
How would you know the shares are trading at $50 and will will make &23.80 per share.
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?