Call Option Payoff Diagram, Formula and Logic
Now you have potentially an unlimited amount of risk if the stock price continues to move higher and higher and higher. That is, all options are with zero or their intrinsic value at expiration. The design is an umbrella type which is applicable from academic to professional presentations. This option strategy might be a little bit different for you. Are option trading fees similar to stock trading fees?
P/L at Different Underlying Prices
All information is for educational purposes only and may be inaccurate, incomplete, outdated or plain wrong. Macroption is not liable for any damages resulting from using the content. No financial, investment or trading advice is given at any time. Home Calculators Tutorials About Contact. We will look at: Call Option Payoff Diagram Buying a call option is the simplest of option trades.
The key variables are: Strike price 45 in the example above Initial price at which you have bought the option 2. Call Option Scenarios and Profit or Loss Three things can generally happen when you are long a call option.
Underlying price is higher than strike price Finally, this is the scenario which a call option holder is hoping for. Call Option Payoff Formula The total profit or loss from a long call trade is always a sum of two things: Initial cash flow Cash flow at expiration Initial cash flow Initial cash flow is constant — the same under all scenarios. It is a product of three things: Cash flow at expiration The second component of a call option payoff, cash flow at expiration, varies depending on underlying price.
Call Option Break-Even Point Calculation One other thing you may want to calculate is the exact underlying price where your long call position starts to be profitable. That is the loss that shows in column three. If you sell the stock at that price, you will have zero gains and zero losses, which is what column three shows. Once our table is constructed, we just need to plot this information on a graph.
This allows us to see how our profitability is affected at various stock prices. Once we do, we get a chart that looks like Figure 4: Profit and loss diagram Long stock Figure 4 is the profit and loss diagram for a long stock position and is simply a picture of the information in Table 7.
You may also hear of these diagrams referred to by other names such as profit and loss chart , profit and loss curve , profit and loss profile , profit and loss payoff structure but they all refer to the same thing. Notice that it is simply a straight line sloping upward to the right. To read the chart, you just select any stock price along the horizontal axis and then trace a vertical line up to or down to the profit and loss line. From there you follow it directly to the left axis and that tells you what your profit or loss would be for that particular stock price.
Notice that the horizontal axis intersects the vertical axis at zero, which is our breakeven point. Anytime a profit and loss line intersects the horizontal axis that represents a breakeven point. For some option strategies, there will be more than one break even point.
Breakeven points are critical since they identify points where you will head into profit loss territory for the next up or down move in the stock. In other words, if you own stock, you make dollar-for-dollar as the stock price rises and lose dollar-for-dollar as the stock price falls. Now take a look at a side-by-side comparison between Table 7 and Figure 5: Even though they are two different ways of expressing the same information, the picture is easier to follow.
It is much harder to visualize the profit and loss behavior by looking at the table. Now, if you are familiar with graphing, you may have figured out that the information in the table would plot as a straight line. However, as we move to the asymmetrical payoffs of options and add more complex strategies, the table will be impossible to follow in your head. To create the profit and loss chart, we must create a table and that always starts with a column of stock prices. However, when dealing in options, we pick the stock prices based on the strike price of the option or options rather than the purchase price as we did for the long stock example.
This is one of the motivations for understanding the third pricing principle we discussed in the previous section. That is, all options are with zero or their intrinsic value at expiration. Either decision will not change the shape of the profit and loss diagram but it would change the profit or loss values.
Now we have our two necessary pieces of information to draw the profit and loss diagram: Now we just need to figure out what our profit or loss will be for the various stock prices in the table.
This same reasoning is used to complete the table for each stock price. Hopefully you are convinced that it is much easier to look at the picture to arrive at this answer rather than going through all of the steps by hand. While it is easy to determine the profits or losses at various stock prices, the advantages of profit and loss diagrams do not stop there. More importantly, we can immediately get valuable insights about the strategy. Call option as leverage. Put writer payoff diagrams. Call writer payoff diagram.
Put-call parity arbitrage I. Put-call parity arbitrage II. Option expiration and price. Video transcript Payoff diagrams are a way of depicting what an option or set of options or options combined with other securities are worth at option expiration.
What you do is you plot it based on the value of the underlying stock price. And I have two different plots here, one that you might see more in an academic setting or a textbook, and one that you might see more if you look up payoff diagrams on the internet, or people actually trading options. But they're very similar.