Options Pricing: Profit and Loss Diagrams

5 stars based on 74 reviews

Let's say you want to by a TV on sale at Wal-Mart. You drive there only to find out that it's "sold out". So you go to the clerk and ask for a "rain check". This "rain check" is a guarantee that you will get the TV for the sale price when they are back in stock. There may be an expiration date on the "rain check" for 1 month from the out of stock date.

This rain check qualifies as an Call option. You have the right to purchase the TV for the sale price up to 1 month regardless of how much the TV goes up or down in price during that period. You are the buying this call option and Wal Mart is the seller.

The only difference of this rain check versus a real option is that there is NO value on this option and it is probably non-transferable. Now, let's use this same concept for a stock. On the other side of this deal, there is someone who is willing to sell you this right for you to buy Microsoft from him for Rain check for TV Expiration Date.

Profit loss VS Price graphs are by far the simplest and most powerful way to communicate the risk and reward assoicated with any option or option spread two or more options. Back to the Microsoft stock option example from above. The contract size is shares. Profit loss Price - microsoft stock Your profits are same as if you had bought Microsoft stock less the option price.

The PL put and call option graphs Price graph consists of: Profit or loss of the position plotted on the Y-axis. Underlying price plotted on the X-axis. The current price of the underlying is located in the center of the X-axis underlying price range. These two graphs represent just buying or selling the instrument stock, future, index. They are simply 45 degree lines which intersect at the current underlying price. For every dollar the underlying price moves up or down, there is an incremental profit loss movement.

Selling the Underlying also is known for stocks is known as put and call option graphs the stock selling the stock without first owning it. Buying a call option: The above graph is shows the profit or loss of buying a call option for a range of projected underlying prices at expiration day for the call option.

Notice below that the loss is limited to the price of the call option if the underlying price at options expiration is LOWER than the current underlying price. Put and call option graphs a put option: The above graph is shows the profit or loss of buying a put option for a range of projected underlying prices at expiration day for the call option. Notice below that the loss is limited to the price of the put option if the underlying price at options expiration is HIGHER than the current underlying price.

Profit and Loss moves incrementally 45 degree angle if the underlying price at options expiration day is LESS than the underlying price today. The above graphs show the profit and loss at put and call option graphs expiration for selling put and call option graphs call or put.

But the profit is limited to the price of the option. For example, if you combine buying a call and buying a put together, this forms a spread known as a straddle:. The straddle spread is a strategy which would profit if the underlying moved considerably put and call option graphs or down. Remaining the same would cause a loss limited to the combined prices of the call and put options.

This position could be reversed to selling a put and selling a call known as a Short Straddle spread. The above Short Straddle position is a neutral strategy profitable if the underlying price remains the same. Maximum profit is the combined prices of the call and put options and maxiumum loss is unlimited. Another common spread position is known as a covered call. This is formed by buying the underlying and sell a call.

Your maximum profit is the price of the call. Your maximum loss is the value of the underlying less the call you sold. You would make money so long as the underlying stayed the same or moved up. Strike price is the price of the underlying that you have the "option" to buy or sell for. For example, a 50 call would mean that you have a right to buy the underlying for 50 before a certain date.

All call and put options have a series of strike prices. This series has a center as the current price of the underlying. For example, if a stock is trading at This strike is also known as the "at the money" option. The 50 call would be the "at the money" call since it is closest to the underlying current price of An "in the money" call would be any call with a strike price LESS than the at the money call.

An "Out of the money" Put strike would be an "In the money" Call strike. When we view the PL chart for varying CALLS, we see that the in the money calls have higher maximum losses, but a lower break even price.

This spread consists of buying one call option of a particular strike price and selling another call option of a different strike price. You can also do the same for puts. The main difference between the credit versus debit spread is that in a credit spread, your sell option price will be greater than your buy option price giving you a net credit when you open the position. The debit put and call option graphs buy price is greater than the sell price giving you a net debit when you open the position.

The PL graph would look like the following:. Notice how the call debit spread has a limited loss as the net put and call option graphs cost of buying and selling the calls. It has a maximum profit as the net difference in the strikes of both calls. For put and call option graphs, assume we buy a 50 call for 2 and sell a 60 call for 1. The maximum loss would be -1, and the maximum gain would be The spread initially gives you a net credit of the sell option price less the buy price.

This is a bearish position which is profitable only as the price of the underlying goes down. The maximum gain is the net credit of the option prices, the maximum loss is the difference in the option strike prices.

Put credit and debit spreads work the opposite way of Calls For a Put debit spread we would: The spread would give us an initial cost of the difference between the buy option and sell option which would also be the maximum loss.

The maximum gain is the difference in the strike prices. It would give you an initial credit of the net cost of the two options with a maximum gain of the difference of the option strike prices.

It is a bullish strategy profitable if the underlying price increases. Here is an easier way to summarize option components when combining them to construct spreads. The ratio spread is usually a three option spread strategy with 1 at the money option combined with 2 out of the money options.

As we can see from the above graphs, backspreads have a lower maximum risk but smaller profit range. Most 4 option spreads form high probability of profit neutral strategies. This high probability of profit comes from the statistical fact that the the underlying price will most likely remain nearly the put and call option graphs given a time limitation. There two main types of four option spreads: The butterfly and the iron condor.

The main difference is that the iron condor combines both call and put options whereas the put and call option graphs is call or put exclusive. Notice how put and call option graphs butterfly spread is a neutral strategy being most profitable when if the underlying put and call option graphs stays the same. Notice also how the loss is limited to the net option price. You can visualize how both credit spreads are overlayed together to form the iron condor.

Notice how the flat iron condor has range put and call option graphs maxiumum profit versus the butterfly having one point. For any PL vs Price chart, you usually see two plots: Here is what the PL vs price today graph would look like as compared to the PL at expiration for a the basic options:.

Observe how the PL vs Price Today would obviously have a zero profit if you closed the position today and the underlying price stayed the same. Also note the non-linear nature of a new undecayed option. As you can see, PL vs Price graphs are a very effective to communicate how options work together to form specific trading strategies.

When in doubt of how your spread strategy will react to any given underlying price change, plot it out on this graph. Once you get the hang of using these graphs, you will be on your way to making more informed options trades.

Copyright Star Research, Inc. All rights reserved, no reproduction or re-transmission of this document is permitted without express permission from Star Research, Inc. Rain check for TV. Call buy or Put sell. Price - microsoft stock.

Binary options pro signals performance bicycles

  • Como operar en forex desde uruguay dubai

    Options strategies for earnings

  • How to make money day trading currency roblox

    Trader bank

Swx europe trading hours

  • Trading brokerage charges comparison of presidential candidates

    Broker forex option binaire regule canada

  • Exbino binary options broker scam review 2016

    Forex podstawy dubai

  • Japanese free binary options indicator download

    Best binary options bonuses 9 tips for new traders top five

Trading binary yang benar

14 comments Opciones de acciones no calificadas versus opciones de incentivos

Real estate brokerage classes nyc

Further we looked at four different variants originating from these 2 options —. Think of it this way — if you give a good artist a color palette and canvas he can create some really interesting paintings, similarly a good trader can use these four option variants to create some really good trades.

Imagination and intellect is the only requirement for creating these option trades. Hence before we get deeper into options, it is important to have a strong foundation on these four variants of options. For this reason, we will quickly summarize what we have learnt so far in this module. Arranging the Payoff diagrams in the above fashion helps us understand a few things better.

Let me list them for you —. Going by that, buying a call option and buying a put option is called Long Call and Long Put position respectively. Going by that, selling a call option and selling a put option is also called Short Call and Short Put position respectively.

However I think it is best to reiterate a few key points before we make further progress in this module. Buying an option call or put makes sense only when we expect the market to move strongly in a certain direction. If fact, for the option buyer to be profitable the market should move away from the selected strike price. Selecting the right strike price to trade is a major task; we will learn this at a later stage. For now, here are a few key points that you should remember —. The option sellers call or put are also called the option writers.

Selling an option makes sense when you expect the market to remain flat or below the strike price in case of calls or above strike price in case of put option. I want you to appreciate the fact that all else equal, markets are slightly favorable to option sellers.

This is because, for the option sellers to be profitable the market has to be either flat or move in a certain direction based on the type of option. However for the option buyer to be profitable, the market has to move in a certain direction. Clearly there are two favorable market conditions for the option seller versus one favorable condition for the option buyer.

But of course this in itself should not be a reason to sell options. This means to say that the option writers earn small and steady returns by selling options, but when a disaster happens, they tend to lose a fortune. Well, with this I hope you have developed a strong foundation on how a Call and Put option behaves.

Just to give you a heads up, the focus going forward in this module will be on moneyness of an option, premiums, option pricing, option Greeks, and strike selection. Once we understand these topics we will revisit the call and put option all over again.

This information is highlighted in the red box. Below the red box, I have highlighted the price information of the premium.

If you notice, the premium of the CE opened at Rs. Moves like this should not surprise you. These are fairly common to expect in the options world. Assume in this massive swing you managed to capture just 2 points while trading this particular option intraday. This translates to a sweet Rs. In fact this is exactly what happens in the real world. Traders just trade premiums.

Hardly any traders hold option contracts until expiry. Most of the traders are interested in initiating a trade now and squaring it off in a short while intraday or maybe for a few days and capturing the movements in the premium. They do not really wait for the options to expire. These details are marked in the blue box. Below this we can notice the OHLC data, which quite obviously is very interesting. The CE premium opened the day at Rs. However assume you were a seller of the call option intraday and you managed to capture just 2 points again, considering the lot size is , the 2 point capture on the premium translates to Rs.

However by no means I am suggesting that you need not hold until expiry, in fact I do hold options till expiry in certain cases. Generally speaking option sellers tend to hold contracts till expiry rather than option buyers. This is because if you have written an option for Rs. So having said that the traders prefer to trade just the premiums, you may have a few fundamental questions cropping up in your mind.

Why do premiums vary? What is the basis for the change in premium? How can I predict the change in premiums? Who decides what should be the premium price of a particular option? Well, these questions and therefore the answers to these form the crux of option trading.

To give you a heads up — the answers to all these questions lies in understanding the 4 forces that simultaneously exerts its influence on options premiums, as a result of which the premiums vary.

Think of this as a ship sailing in the sea. The speed at which the ship sails assume its equivalent to the option premium depends on various forces such as wind speed, sea water density, sea pressure, and the power of the ship. Some forces tend to increase the speed of the ship, while some tend to decrease the speed of the ship.

The ship battles these forces and finally arrives at an optimal sailing speed. Crudely put, some Option Greeks tends to increase the premium, while some try to reduce the premium.

Try and imagine this — the Option Greeks influence the option premium however the Option Greeks itself are controlled by the markets. As the markets change on a minute by minute basis, therefore the Option Greeks change and therefore the option premiums! Going forward in this module, we will understand each of these forces and its characteristics. We will understand how the force gets influenced by the markets and how the Option Greeks further influences the premium.

We will do the same in the next chapter. A quick note here — the topics going forward will get a little complex, although we will try our best to simplify it. While we do that, we would request you to please be thorough with all the concepts we have learnt so far. Thanks a lot for sharing learning material, it is really helpful for beginners like me to understand the concept and strategy of share market..

We are trying out best to complete the modules as fast as we can. European option means the settlement is on expiry day. However, you can just speculate on option premiums…and by virtue of which, you can hold the position for few mins or days. Also we have potential of unlimited profit in long call or long put and even we can trail stoploss of premiums. Thank you so much for your articles sir. Cause sitting in front of computer is not possible. Even if we r there we may miss the trade id doing some thing else at the time we are suppose to trade or squareoff the tyrade.

Till now it has been very clear and crisp. Thanks for that and hope that further chapters will also come the same way. We will be discussing SL based on Volatility very soon.

Request you to kindly stay tuned till then. We certainly hope to keep the future chapters as easy and lucid as the previous ones have been. Hi Really nice initiative sir. Hello Sir, if I buy a lot of , call option of strike price at a premium of Rs 2 with a spot price of Now if the price moves to and premium is now at 3 so would be my profit?? Firstly, if the spot moves from to , the premium of the Call option will certainly be more than Rs. Your profits would be —.

Hello Sir, I am still confused with the way the profit is calculated. Might be, I am not able to get what u explained and I am really sorry for asking it again. In some of your replies, you mentioned that the profit is calculated as per the difference of spot price and strike price and in some replies u mentioned that it is as per the difference of premium.

In case of 1 lot of shares the profit would be. So which of the above options are correct??? Is there a difference if I am closing my position before expiry or excersize it at expiry? For all practical purposes I would suggest you use the 2nd way of calculating profits…i. Do remember the premium paid for this option is Rs 6. Irrespective of how the spot value changes, the fact that I have paid Rs. This is the cost that I have incurred in order to buy the Call Option.

Please note — the negative sign before the premium paid represents a cash out flow from my trading account. This lead to my confusion. Got your point, see if you are holding the option till expiry you will end up getting the amount equivalent to the intrensic value of the option.

I have explained more on this in the recent chapter on Theta…but I would suggest you read up sequentially and not really jump directly to Theta. The calculation provided by karthik in chapter 3 is for expiry calculation on expirt date.. Hope this clears your doubt.. The minimum value for this option should be STT stands for Security Transaction Tax, which is levied by the Government whenever a person does any transaction on the exchange.